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1-1-1985
Damages for Breach of Contract

Robert Cooter
Berkeley Law
Melvin Aron Eisenberg

Berkeley Law
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Part of the Contracts Commons
Recommended Citation
Damages for Breach of Contract, 73 Cal. L. Rev. 1432 (1985)
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California Law Review
VOL. 73 OCTOBER 1985 No. 5
Copyright © 1985 by California Law Review, Inc.

Robert Cooter
and Melvin Aron Eisenberg
TABLE OF CONTENTS
PAGE
I. THE MEANING OF INJURY AND COMPENSATION ........... 1435
II. BASIC DAMAGE FORMULAS ............................... 1438
A. Substitute-Price....................................... 1439
B. Lost-Surplus .......................................... 1439
C. Opportunity-Cost...................................... 1440
D. Out-of-Pocket-Cost.................................... 1442
E. Diminished-Value..................................... 1442
F Add-Ons and Offsets .................................. 1442
III. COMPENSATORY DAMAGES AND MARKET STRUCTURE .... 1444
A. Perfectly Competitive Markets ......................... 1445
L The TraditionalModel of Business Conduct in
Perfectly Competitive Markets ..................... 1445
2. The Statistical-PlanningModel of Business Conduct
in Perfectly Competitive Markets ................... 1449
B. Imperfectly Competitive Markets ....................... 1451
1. The TraditionalModel of Business Conduct in
Imperfectly Competitive Markets ................... 1451
2. The Fishing Model of Business Conduct in
Imperfectly Competitive Markets ................... 1455
IV. WHAT MEASURE OF DAMAGES SHOULD THE LAW
PREFER? . . . .. .. . . . .. . . . . .. . . . . .. . . . . .. . . . . .. . . . .. .. . . . . ... 1459
A. The General Case ..................................... 1459
1. Performance ...................................... 1462
2. Precaution ........................................ 1464
3. Reliance .......................................... 1465
1432
HeinOnline -- 73 Cal. L. Rev. 1432 1985

DAMAGES FOR BREACH OF CONTRACT 1433
B. The Limits of the Expectation Principle ................ 1468

CONCLUSION ................................................... 1475
APPENDIX ..................................................... 1478
A. Substitute-Priceand Opportunity-CostDamages ........ 1478
B. Lost-Surplus Damages ................................ 1478
C. Out-of-Pocket-Cost Damages .......................... 1480

1434 CALIFORNIA LAW REVIEW [Vol. 73:1432
Robert Cootert
and Melvin Aron Eisenbergl
The conventional analysis of contracts holds that the purpose of

damages is to compensate the victim of breach for his injury. This pur-
pose, in turn, is normally to be accomplished by awarding expectation
damages-that is, the amount required to put the injured party where he
would have been if the contract had been performed.' The goal, compen-
sation, and the means, expectation damages, are so ingrained in contract
law as to seem self-evident. On closer analysis, however, the meanings of
injury, compensation, and expectation are ambiguous, and, partly for
that reason, it is far from clear that expectation damages are always com-
pensatory in nature. The purpose of this Article is to consider the mean-
ings of these critical concepts, to develop certain theoretical and actual
measures of contract damages, and to analyze the relationship between
these measures and the ends of fairness and economic efficiency. Among
the propositions we seek to establish are the following:
(1) Under certain conditions, reliance and expectation damages
will be virtually identical.
(2) In the typical case in which the two measures diverge, the
use of expectation damages can be defended on grounds of fairness
and efficiency.
(3) In most cases, the major variables that determine the best
method for measuring expectation damages are market structure and
business conduct.
(4) A distinction must be drawn between the concept that
expectation damages should place the injured party where he would
have been if the contract had been performed, and the concept that
expectation damages should replicate the damage term the parties
would probably have agreed to if they had bargained under ideal con-
t Professor of Law and Economics (Jurisprudence and Social Policy), Boalt Hall School of
Law, University of California, Berkeley. B.A. 1967, Swarthmore College; B.A. 1969, Oxford
University; Ph.D. 1975, Harvard University.
t Koret Professor of Business Law, Boalt Hall School of Law, University of California,
Berkeley. A.B. 1956, Columbia College; LL.B. 1959, Harvard University.
An earlier version of this paper was presented at the Stanford Law and Economics Seminar.
We are indebted to Mitchell Polinsky, Alan Schwartz, and the participants at that Seminar for their
valuable comments.
1. See, ag., RESTATEMENT (SECOND) OF CoNmcRAs § 344(a) (1981).

1985] DAMAGES FOR BREACH OF CONTRACT 1435
ditions. In most cases, damages under the two concepts will be virtu-
ally identical, but in some cases they will diverge.
Throughout, we will give particular attention to the vexing issue, under
what circumstances is it appropriate to compensate a victim of breach for
lost volume?
I
THE MEANING OF INJURY AND COMPENSATION
In a contract setting, the term "injury" can have two different mean-
ings. One meaning is being worse off than if the contract had been per-
formed. Another meaning is being worse off than if the contract had not
been made.2 The interests invaded by these two injuries are known as the
expectation and reliance interests, respectively.
The two distinct meanings of injury correspond to two distinct pur-
poses of damages for breach of contract. Expectation damages are
designed to protect the expectation interest, and have the purpose of
placing the victim of breach in the position he would have been in if the
other party had performed. If this purpose is achieved, the potential vic-
tim of breach is equally well off whether there is performance, on the one
hand, or breach and payment of damages, on the other. In contrast, reli-
ance damages are designed to protect the reliance interest, and have the
purpose of restoring the victim of breach to the position he would have
been in if the contract had not been made. If this purpose is achieved,
the potential victim of breach is equally well off whether there is no con-
tract with the breaching party, on the one hand, or contract, breach, and
payment of damages, on the other.
In our legal system compensation is measured in money. We will
use the term "perfect compensation" to mean a sum of money sufficient
to make the victim of an injury equally well off with the money and with
the injury as he would have been without the money and without the
injury. In this sense, compensatory damages are the money equivalent of
the injury. The idea of a money equivalent to injury can be clarified with
help from economic theory. Economists measure the well-being of indi-
viduals by the amount of satisfaction they enjoy, and the well-being of
firms by their profits. Compensation for an injury is perfect if it enables
the victim to enjoy the same level of satisfaction or profits as would have
prevailed without the injury.
Computing compensatory damages involves comparing the victim's
uninjured state with the injured state in order to estimate how much
money is needed to make up the difference. Because there are two differ-
ent conceptions of the uninjured state in a contract setting, there are also
2. See id. § 344(a), (b).

two different conceptions of compensation. Under the expectation con-

ception, compensation is the amount required to put the victim in a state
just as good as if the breaching party had performed the contract. Under
the reliance conception, compensation is the amount required to put the
victim in a state just as good as if he had not made the contract with the
breaching party.
These concepts can be illustrated by an economic analysis of the
well-known case of Hawkins v. McGee.3 To summarize the facts, a physi-
cian induced a boy to submit to an operation by promising to make the
boy's injured hand perfect, but the actual operation made the hand irre-
versibly worse. The relationship between the extent of the injury and
compensatory damages are represented by the graph in Figure 1. The
Figure 1: Compensation in Hawkins v. McGee
Curve
$10,000
(expectation)
$5,000 Curve
(reliance)
0% 25% 50% 100%

Totally (After) (Before) Perfect
Disabled
Hand's Condition
horizontal axis in this Figure indicates the range of possible conditions of

the hand, which vary from totally disabled to perfect. The vertical axis
indicates dollar amounts of damages. The curved lines on the graph
delineate the relationship between the extent of the disability and the
amount of money needed to compensate for it. These curves are con-
3. 84 N.H. 114, 146 A. 641 (1929).

19851 DAMAGES FOR BREACH OF CONTRACT 1437
structed so that a change in the patient's condition from one point to

another on the same curve leaves his welfare unchanged, because a
change in disability is exactly offset by a change in money compensation.
Consider first expectation damages in Hawkins v. McGee, which are
graphed by the curved line labeled "expectation." The physician prom-
ised to make the boy's hand perfect. Under the expectation conception,
the uninjured state is the condition the patient would have been in if the
physician had performed his promise. If the promise had been per-
formed, the patient would have received a perfect hand and no compen-
sation. Assume that after the operation the patient's hand was 25%
perfect. Expectation damages are the amount of money needed to com-
pensate for the shortfall between the 100% perfect hand that was prom-
ised and the 25% perfect hand that was achieved. To measure these
damages, locate the 25% point on the horizontal axis, move vertically up
to the curve labelled "expectation," and then move horizontally over to
the vertical axis to determine the corresponding dollar amount, which is
$10,000. By construction, the patient is as well off with $10,000 in dam-
ages and a 25% perfect hand as with no damages and a 100% perfect
hand. Thus expectation damages equal $10,000, because this sum of
money compensates for the shortfall between actual and promised per-
formance. (Note that the expectation curve and the resulting $10,000
figure illustrate the logic of compensation, not the damages actually com-
puted in Hawkins v. McGee.)
Now consider reliance damages, which are graphed by the curved
line labeled "reliance." Under the reliance conception, the uninjured
state is the condition in which the patient would have been if he had not
made the contract with the breaching party. Assume that if there had
never been a contract the patient would have had a 50% perfect hand,
whereas after the operation the hand was 25% perfect. Reliance dam-
ages are the amount of money needed to compensate for the deterioration
of the hand from 50% to 25%. 4 Like the expectation curve, the reliance
curve is constructed to represent the relationship between the extent of
the disability and the amount of money needed to compensate for it. The
only difference is that the reliance curve touches the horizontal axis at
the point where the hand is 50% perfect, rather than 100% perfect. By
following the same steps as in expectation damages, we find that the
patient is equally well off with $5,000 in damages and a 25% perfect
hand as with no damages and a 50% perfect hand. Thus reliance dam-
ages equal $5,000. In short, the formal difference between expectation
4. We assume here that the operation performed by the defendant, Dr. McGee, did not cause
Hawkins to lose an opportunity to go to another doctor who would perform the operation
successfully. The modification of reliance damages dictated by such a lost opportunity is explained in
Section C of Part II.

and reliance damages is the baseline against which the injury is mea-
sured, where "baseline" refers to the uninjured state.
The compensation curves in Figure 1 are formally identical to indif-
ference curves in consumer theory. An indifference curve is a line con-
necting all bundles of commodities yielding an equal amount of utility to
the consumer. "Utility" is a term of art describing satisfaction or wel-
fare.' Perfect compensation is that sum of money that increases the
wealth of an injured person just enough to provide the same level of well-
being as if he had no injury. The compensation curves in Figure 1 show
the damages required for perfect compensation of various degrees of
injury. Thus the compensation curves are lines of constant utility, or
indifference curves.'
This analysis of compensation can be applied to firms by substitut-
ing "profit" for "utility." In technical terms, the only change involved is
the substitution of profit functions for utility functions; the same graph
can be used, with the curves interpreted as lines of constant profit rather
than lines of constant utility. Generally, however, it is more illuminating
to revise the graph and work with supply and demand curves. That
approach is taken in the balance of this Article.
II
BASIC DAMAGE FORMULAS
Under conventional contracts doctrine, protection of the expecta-
tion interest requires an award such that the injured party will achieve
the level of satisfaction (if a consumer) or profits (if a firm) that would
have been achieved if the contract had been performed. Similarly, under
conventional contracts doctrine, protection of the reliance interest
requires an award such that the injured party will achieve the level of
satisfaction or profits that would have been achieved if the contract had
never been made. We will refer to these doctrines as the expectation
principle and the reliance principle.
In practice, a general inquiry into satisfaction or profits is often
infeasible. Therefore, the expectation and reliance principles must be
implemented by more specific formulas. In Part II, we delineate five for-
mulas which together cover the great run of cases. We call these the
5. There is a long history of dispute in economics about the interpretation of the utility curve.
See, eg., Stigler, The Development of Utility Theory, 58 J. POL. ECON. 307, 373 (1950). For a
different view, see Cooter & Rappaport, Were the Ordinalists Wrong About Welfare Economics?, 22
J. ECON. LITERATURE 307 (1984).
6. The formal similarity between constant utility and compensatory damages masks some
substantive differences between the economic and legal concepts. For example, economists usually
measure a consumer's well-being by his individual preferences, whereas measures of value used in
law are often standardized and objective. See Eisenberg, The Responsive Model of ContractLaw, 36
STAN. L. REv. 1107 (1984). However, these differences do not affect the analysis in this Article.

substitute-price, lost-surplus, opportunity-cost, out-of-pocket-cost, and

diminished-value formulas. Almost all of the basic measures currently
used by the courts in breach-of-contract cases are variants of these five
formulas.
A. Substitute-Price
When a party to a contract breaks his promise, the victim of breach
may replace the promised performance with a substitute performance.
The substitute-price formula awards the victim of breach the cost of
replacing a promised performance with a substitute performance. To
illustrate, suppose that Apex Ticket Agency offers cinema tickets at the
pricepk and that a consumer orders Xk tickets. After Apex breaches, the
consumer cannot get equivalent tickets except by paying the high price p,
to Bijou Ticket Agency. The promised performance can be replaced at
the cost Xk (Ps - pk). Accordingly, this is the amount of money that
would be awarded as damages to the consumer under the substitute-price
formula. (Of course, the parties could be reversed in the example, so that
seller had to find a substitute buyer, rather than the buyer finding a sub-
stitute seller.)
If a commodity is homogeneous, a substitute performance may be
identical to the promised performance. In that case, the substitute price
is the actual price of a substitute transaction. To illustrate, the tickets
promised by Apex may be identical to those sold by Bijou, in which case
the substitute-price formula equals the actual cost of substitution. How-
ever, if the commodity is differentiated, rather than homogeneous, so
that no perfect substitute exists, the substitute price must be computed by
extrapolation from comparable market transactions. For example, the
substitute price of a four-door 1957 Chevrolet might be computed by
extrapolation from the selling prices of a two-door 1957 Chevrolet and
four-door 1956 and 1958 Chevrolets.
B. Lost-Surplus
Usually, each party expects to gain from a contract. The difference
between the value that a party places upon what he expects to receive
and give up is called surplus. The lost-surplusformula awards the victim
of breach the surplus that he would have enjoyed if the breaching party
had performed.
The surplus that a seller enjoys on the sale of a commodity is nor-
mally the difference between the contract price of the commodity and its
direct cost. To illustrate, if the cost c of tickets to the Apex Ticket
Agency is their wholesale price, and if a consumer promises to purchase
Xk tickets at the contract pricePk, then the surplus Apex expects on the

contract is Xk (Pk - c). This amount equals the seller's damages under
the lost-surplus formula.
Now consider the lost-surplus formula when the roles of the parties
are reversed. The surplus that the consumer enjoys on a purchase is nor-
mally the difference between the value of the good to him, which is called
his willingness-to-pay, and the amount he actually pays. 7 Using the same
illustration, assume the consumer would have been willing to pay as
much as p,, for each of Xk tickets, and the contract price is Pk. The con-
sumer's expected surplus from the contract with Apex is the difference
between what he is willing to pay for the tickets and what the contract
requires him to pay.' Damages for Apex's breach under the lost-surplus
formula therefore would be Xk (P, - Pk).
C. Opportunity-Cost
Making a contract often entails the loss of an opportunity to make
an alternative contract. The opportunity-costformula awards the victim
of breach the surplus that he would have enjoyed if he had signed the
best alternative contract to the one that was breached. To illustrate,
assume that a consumer forgoes the opportunity of buying Xk cinema
tickets from Bijou at price po, and instead contracts to buy Xk tickets
from Apex at pricePk. If he is then compelled to purchase at the higher
price p, after Apex's breach, the opportunity-cost formula sets damages
equal to Xk (p. - p). In general, if breach causes the injured party to
purchase a substitute performance, the opportunity-cost formula equals
the difference between the best alternative contract price available at the
time of contracting and the price of the substitute performance obtained
after breach.
As another illustration, our account of Hawkins v. McGee in Part I
of this Article implicitly assumed that the operation performed by the
defendant, Dr. McGee, did not cause Hawkins to lose the opportunity of
having another doctor perform the operation successfully. If such an
opportunity were lost, its value would need to be included in the compu-
tation of reliance damages. The value of the forgone opportunity
depends upon how close to perfection the hand would have been after an
operation by another doctor. To illustrate, suppose that another doctor
would have restored the hand to the 75% level. The injury from relying
on Dr. McGee is then the difference between the 75% level that the other
7. For an account of consumer's surplus and its relationship to the expenditure function and
demand curves, see H. VARIAN, MICROECONOMIC ANALYSIS 207-13 (1978).
8. In the usual formulation, the willingness-to-pay function, p,, = p, (x), is the inverse of the
demand function. The total willingness-to-pay is thus the integral under the demand curve. The
best way to represent these facts is through the use of the expenditure function. See Cooter, A New
Expenditure Function, 2 ECON. LETTERS 103 (1979); Diamond & McFadden, Some Uses of the
Expenditure Function in Public Finance, 3 J. PUB. ECON. 3 (1974).

doctor would have provided and the 25% level achieved by Dr. McGee,
not the difference betrween the 50% level before the operation by Dr.
McGee and the 25% level after it. In general, when reliance causes an
opportunity to be lost, the lost opportunity provides a higher baseline for
measuring the injury than the actual state before the agreement, and the
higher baseline in turn results in higher damages.
To depict reliance damages under the opportunity-cost interpreta-
tion, it is necessary to add another curve to Figure 1. The additional
curve, as depicted in Figure 2, touches the horizontal axis at the 75%
point, and, as with the first two curves, it is constructed so that every
point on it represents the same level of welfare. Consequently, a change
in the hand's condition represented by a move along the new curve is
exactly offset by the corresponding change in damages. Once the new
curve is drawn on the graph, the value of the lost opportunity is read off
the graph by moving vertically from the 25% point on the horizontal
axis up to the intersection with this new curve, and then moving horizon-
tally to the intersection with the vertical axis. Following these steps, the
opportunity-cost measure of damages is $8,000, which is less than expec-
tation damages ($10,000) and more than reliance damages stripped of the
opportunity cost ($5,000).
Figure 2: Opportunity Cost in Hawkins v. McGee
Damages
Curve
Curve
$10,000
$8,000
(opportunity)
$5,000
(reliance)
0% 25% 50% 75% 100%

(After) (Before) (Alternative) (Promised)
Hand's Condition

D. Out-of-Pocket-Cost
Action in reliance on a contract may involve an investment that can-
not be fully recouped in the event of breach. The out-of-pocket-cost
formula awards the victim of breach the difference between (1) the costs
incurred in reliance on the contract prior to breach, and (2) the value
produced by those costs that can be realized after breach. To illustrate,
assume that a consumer breaches an agreement to buy Xk tickets from
Apex at price Pk. In reliance on the contract, Apex purchased Xk tickets
at the wholesale price ci. At the time of breach, the spot price p,, at
which Apex can resell tickets, has fallen below the wholesale price cj
paid by Apex. Apex's out-of-pocket cost is Xk (Ci - ps). Reversing roles,
suppose the consumer contracts with Apex for theater tickets and then
contracts with a baby-sitting service for the evening of the performance.
Apex breaches, and the consumer therefore stays home that evening.
The consumer's out-of-pocket cost is the cost of cancelling the baby-sit-
ting contract. 9
E. Diminished-Value
When performance of a contract is partial or imperfect, the value
received is less than promised. The diminished-valueformula awards the
victim of breach the difference between (1) the post-breach value of a
commodity that was to be received or improved under the contract, and
(2) the value the commodity would have had if the contract been prop-
erly performed. To illustrate, suppose that Seller promises Buyer to cus-
tomize a boat with an Alpha compass, which will give the boat a market
value of m. Instead, he delivers a boat with a Beta Compass, which
causes the boat to have a lower market value of md. The amount that
would be awarded to Buyer under the diminished-value formula is
rap - Md, or the difference between the value of the boat promised and
the value of the boat delivered.
F Add-ons and Offsets

In some cases, special circumstances require amending a basic
formula to include additional terms. For example, a breach may create
an opportunity for the injured party to engage in a surplus-producing
transaction that would not have been possible but for the breach. To
illustrate, if in the theater-ticket example the concert is sold out, breach
by the consumer frees up Xk tickets, which Apex then may sell to some-
one else at the spot price p.. In such circumstances the lost-surplus
formula must be corrected to avoid overcompensation relative to the
9. If the consumer paid c, in advance for the baby-sitting services, and a refund of P, is
recoverable after cancelling, then the out-of-pocket cost to the consumer is c - p,.

expectation principle or the reliance principle. 0 Alternatively, a breach

may result in losses beyond those contemplated by the basic formulas.
For example, suppose A breaches a contract to sell to B a machine that B
intends to use on his assembly line. The substitute-price formula must be
corrected in such circumstances in order to avoid undercompensation,
because B's loss includes not only the additional cost of a substitute
machine, but also the profits lost by disruption of his assembly line while
obtaining a substitute.
TABLE 1: DAMAGE FORMULAS

Formula Breaching Formulas
Party
Substitute-Price buyer contract price - spot price (Pk--Ps)
seller spot price - contract price (Ps-Pk)
Lost-Surplus buyer contract price - cost (Pk-C)
seller willingness to pay - contract price (Pw-Pk)
Opportunity-Cost buyer forgone price - spot price (Po-Ps)
seller spot price - forgone price (P-Po)
Out-of-Pocket-Cost buyer costs incurred - realizable value (ci-vr)
seller costs incurred - realizable value (ci-vr)
Diminished-Value buyer promised value - received value (vp-,r)
seller promised value - received value (vp-v,)
When computing damages, courts usually use some variant of one of

the five basic formulas, which are summarized in Table 1. However, the
circumstances in which each formula will be truly compensatory are not
obvious. To explore these circumstances, which is the task of the next
Part, we must focus on the central points and omit distracting details.
We have discussed five damage formulas, as well as add-ons and offsets,
in the context of breach by the buyer and the seller. A complete survey
of all these permutations in different circumstances would unduly expand
this Article, so for the most part we will restrict our discussion to the first
four formulas and the case of buyer's breach. Generally speaking, the
principles developed in this analysis can be extrapolated to cover the
10. The lost-surplus formula, corrected for the offset, awards damages equal to the surplus
expected on the contract less the surplus made possible by the breach. In our example, corrected
damages equal Xk(Pk - c) - xk(p. - c) = Xk(pk - Ps). Notice that in this example the corrected
lost-surplus formula collapses into the substitute-price formula.

omitted issues-seller's breach, the diminished-value formula,1 1 add-ons,

and offsets.
III
COMPENSATORY DAMAGES AND MARKET STRUCTURE
As explained in Part I, the expectation and reliance conceptions of

damages describe the uninjured state differently. Under the expectation
conception, the uninjured state is that which would exist if there were
performance, whereas under the reliance conception the uninjured state
is that which would exist if there had been no contract. If the victim's
level of satisfaction or profits in the uninjured state is the same under
both conceptions of injury, then damages under the expectation principle
equal damages under the reliance principle. Otherwise, the two concep-
tions of compensation yield different amounts of damages
Part III will explore the selection of the correct formula to measure
damages under the expectation and reliance principles, and the condi-
tions under which expectation and reliance damages diverge. Intuitively,
the selection of the correct formula, and the convergence or divergence of
expectation and reliance damages, might seem to depend on a number of
variables: the position of the injured party (buyer or seller); the nature of
the injured party (consumer or merchant); the nature of the product
(goods or services); the motive for contracting (allocating risk of price
changes or assuring a reliable supply); the manner in which a firm con-
ducts its business (advertising or no advertising, mark-up or marginal-
cost pricing, large inventory or small inventory); and the structure of the
market (competitive or noncompetitive). We will show that the last two
variables-business conduct and market structure-are fundamental to
the choice of a proper damage formula. Part III, Section A, explores the
problem in perfectly competitive markets by examining two models of
business conduct: a traditional model, and a non-traditional model that
we call the model of statistical planning. Part III, Section B, explores the
problem in imperfectly competitive markets. Again, we use two models
of business conduct: a traditional model, and a non-traditional model
that we call the fishing model. In both Section A and Section B, we will
give particular attention to the question of when, if ever, it is appropriate
to employ a damage formula that compensates the victim of breach for
lost volume.
11. For a discussion of diminished-value damages, see Eisenberg, supra note 6, at 1156-65.

A. Perfectly Competitive Markets

L The TraditionalModel of Business Conduct in Perfectly
Competitive Markets
According to the traditional model of business conduct, a seller in a
perfectly competitive market produces until his incremental cost equals
the market price of the good, and buyers purchase all of his production.
Consequently, the market clears in each period and everyone buys and
sells as much as he wants. In a perfectly competitive market, which, by
definition, has many similar buyers and sellers, anyone who signs a con-
tract could have contracted with someone else on the same terms. If,
under such circumstances, the party injured by a breach had not con-
tracted with the breaching party, it would have been both possible and
advantageous to contract with someone else on the same terms as the
breached contract. But for having made the breached contract, the
injured party presumably would have made such an alternative contract.
If the injured party had made the forgone contract instead of the
actual contract, it is possible that the forgone contract would also have
been breached. In many cases, however, the probability of breach is
small. As the probability of breach approaches zero, the expected value
of a contract approaches the value of performance. This in turn implies
that the opportunity cost of a forgone contract approaches the value of
performance of a contract that is made. The value of performance of a
contract that is made determines expectation damages, and the opportu-
nity cost of a forgone contract determines reliance damages. Thus, if a
market is perfectly competitive and the parties' conduct is described by
the traditional model of business conduct in such a market, reliance dam-
ages approach expectation damages as the probability of breach
approaches zero. 2
This analysis can be illustrated by two examples.
Example A. Buyer wants to purchase a customized boat. The
contract market for customized boats is competitive (many dealers
and many buyers), the parties' business conduct is described by the
traditional model, and the rate of breach is low. Buyer chooses Seller
and contracts for the boat. On the delivery date, Buyer tells Seller he
will refuse to accept delivery because a change in his circumstances
has eliminated his need for a boat. The spot market for boats is also
competitive, but the customizing has no resale value. Seller resells
the boat on the spot market and sues Buyer to recover damages for
breach of contract.
12. Cf Fuller & Perdue, The Reliance Interest in Contract Damages (pL 1), 46 YALE L.J. 52,
62-63 (1936); Goetz & Scott, Enforcing Promises An Examination of the Basis of Contract, 89 YALE
L.J. 1261, 1284 (1980).

In this example, Seller would have contracted with another buyer

but for the breached contract, and it is very likely that the alternative
buyer would have performed. Consequently, reliance damages, which
put Seller in the position he would have been in if he had not contracted
with Buyer, virtually equal expectation damages, which put Seller in the
position he would have been in if Buyer had performed.
Example B is identical to Example A, except that the motive for
contracting is not to customize goods, but to hedge against a price
increase.
Example B. Buyer wants a ton of coal delivered in six months.
The market for coal is competitive, the parties' business conduct is
described by the traditional model, and the rate of breach is low.
Prices for coal fluctuate because of variations in demand that are diffi-
cult to foresee. Buyer is averse to the risk of price fluctuations,
whereas Seller is neutral with respect to such risks, so the parties
contract for Seller to deliver the coal in six months at an agreed price.
On the delivery date, Buyer's circumstances have changed and he has
no use for coal. Furthermore, the spot price has fallen below the
contract price, so Buyer does not want the coal for resale. Buyer
13
breaches and Seller sues for damages.
The essential facts pertaining to damages in Example B are the same
as in Example A. If Seller in Example B had not contracted with Buyer,
he would have contracted on virtually identical terms with someone else
who probably would have performed. Consequently, putting Seller in
the position he would have enjoyed if Buyer had performed is virtually
the same as putting him in the position he would have enjoyed if he had
not contracted with Buyer.
Now we explain this case by using a graph. Figure 3 depicts the
situation of a Seller like the one in Example A, who bid in a competitive
market to customize a boat. The only difference is that in Figure 3 the
example is simplified by assuming that the commodity is measured in
continuous units, like petroleum, rather than discrete units, like boats.
Demand in the contract market is denoted by the line plakD, which is
drawn horizontally to indicate that Seller can sell as many units as he
wishes at the contract pricepk. (If the demand curve faced by Seller were
not horizontal, the market would not satisfy the assumption of perfect
competition.) In the event of breach, the commodity will be resold on
the spot market. Demand in the spot market is denoted by the line p.D,
which also is drawn horizontally to indicate that this market also is com-
petitive. The contract price, Pk, lies above the spot price, p,. The mar-
13. A sophisticated treatment of the price-hedging motive for contracting can be found in
Perloff, The Effects of Breaches on Forward ContractsDue to UnanticipatedPrice Changes, 10 J.
LEGAL STUD. 221 (1981).

Figure 3: Competitive Market for Customized Goods
Price c Marginal Cost
Pk Dk Contract Demand
A D, Spot Demand
Xk
Quantity
ginal cost is represented by the curve c. If the rate of breach is zero, Seller
will maximize profits by signing contracts until the marginal cost of sup-
plying the good equals the contract price, which occurs at the quantity
denoted xk. If the rate of breach is small, Seller might shade his produc-
tion so that it is a little short Of Xk. We assume that the rate of breach is
so small that Xk is a close approximation of the profit-maximizing level of
14
production.
We shall now illustrate the implementation of the expectation and
reliance principles, by applying the damage formulas developed in Part II
14. Figure 3 is based on Example A. The same relationships would hold if we used Example B,
and revised Figure 3 accordingly. To demonstrate this proposition, we can show that the same
essential set of facts about production and profit prevails in Example B as in Example A. Suppose
the spot price of coal assumes a high valuepsh half the time and a low valuepsI half the time. Seller
produces x units and promises to deliver xh units, planning to fill its contracts either from its own
production or from purchases on the spot market. If the spot price should assume its high valueph
in the current period, the buyer performance will equal xh. If x < xh, there will be a shortfall in
Seller's production relative to buyer performance. Unlike Example A, Seller in ExampleB can make
up for a shortfall in production by a purchase on the spot market, denoted xh - x. On the other
hand, if the spot price assumes its low valueps, then breaches by buyers will cause their performance
to fall to x I . If x > x1 , Seller will have excess production relative to buyer performance, so he will
have to dispose of a certain number of units on the spot market, denoted x - x 1 . In either case, the
value of the marginal unit of output to Seller is the spot price. Consequently, if Seller is risk-neutral
he will produce until the marginal cost of production equals the average spot price.
If Seller is risk-neutral, then he can spread risk without cost. If risk can be spread without cost,
then there will be no payment for the service of spreading risk in a competitive market. If risk-
spreading is uncompensated, then the contract price must equal the average spot price. However, if
risk spreading is costly then a payment will be made for the service of spreading risk, causing the
long run competitive equilibrium contract price to exceed the average spot price.

to Example A and Example B. We shall do so here in words; the Appen-

dix to this Article contains a technical explanation using the mathemati-
cal notation in Figure 3.
Under the conditions stated in Example A and Example B, the sub-
stitute-price formula, by awarding the difference between the contract
price and the spot price after breach, restores Seller's revenues to their
expected level. In these examples, Seller's costs are unaffected by the
breach."1 Profits are, by definition, the difference between revenues and
costs. Since revenues are restored to their expected level and costs
remain unaffected, the substitute-price formula restores profits to their
expected level, as required by the expectation principle. We conclude
that, in a perfectly competitive market with business conduct described
by the traditional model and with a low rate of breach, the substitute-
price formula protects the expectation interest.
We now turn to a parallel argument concerning the implementation
of the reliance principle. In Example A and Example B, Seller would
have contracted with someone else on the same terms if he had not con-
tracted with breaching Buyer. Under the conditions stated in these
examples, the opportunity-cost formula, by awarding the difference
between the forgone price on the alternative contract and the spot price
prevailing after breach, restores Seller's revenues to their forgone level,
by which we mean the level that would have been created by performing
the alternative contract. Seller's costs in these examples are unaffected
by the breach, and profits are by definition the difference between reve-
nues and costs. Since revenues are restored to their forgone level and
costs remain unaffected, the opportunity-cost formula restores profits to
their forgone level. Assuming the probability of breach on the forgone
contract is small, restoring profits to their forgone level is required by the
reliance principle. We conclude that, in a perfectly competitive market
with business conduct described by the traditional model and a low rate
of breach, the opportunity-cost formula protects the reliance interest.
Furthermore, it is easy to show that, under these conditions, dam-
ages are the same under the substitute-price formula and the opportu-
nity-cost formula, which illustrates the equivalence of expectation and
reliance damages under these conditions.16
In contrast, the other two formulas-out-of-pocket costs and lost
surplus--do not generally protect the expectation or reliance interest in
15. The examples could be changed so that Seller's costs are affected by breach. His costs
would be affected if, in order to mitigate damages, he stopped production upon receiving notice of
breach and thus did not finish producing the breached units.
16. The substitute-price formula awards the difference between the contract price and the spot
price. The opportunity cost formula awards the difference between the forgone price and the spot
price. In Example A and Example B, the forgone price equals the contract price, so the two
formulas yield the same damage award.

circumstances like Example A and Example B. The out-of-pocket-cost

formula fails to take account of the opportunity lost as a result of making
the breached contract, so it does not protect the reliance interest, much
less the expectation interest. The lost-surplus formula awards damages
equal to the profits expected from the breached contract. In a perfectly
competitive market in which the parties' business conduct is described by
the traditional model, however, Seller expects no profits on the marginal
contract, that is, a contract involving one unit of his production. 7 The
lost-surplus formula therefore awards no damages for marginal breach
even though the expectation and reliance interests have been injured.1
More generally, when breach involves many units instead of just a margi-
nal unit, the lost-surplus measure can undercompensate or overcompen-
sate, as demonstrated in the Appendix. 9 We conclude that, in a
perfectly competitive market with business conduct described by the
traditional model and with a low rate of breach, the lost-surplus and out-
of-pocket-cost formulas do not protect the expectation and reliance
interests.
2. The Statistical-PlanningModel of Business Conduct in Perfectly

Competitive Markets
Expectation and reliance damages are equal in Example A and
Example B because the market is competitive, the rate of breach is low,
and business conduct is described by the traditional model. Assume now
that the market is competitive, the seller enters into a large number of
contracts, and the rate of breach is high but predictable. In such a case, a
rational seller may produce fewer units than he has contracted to sell, or
may make available during each period more units than are invariably
cleared. To illustrate, suppose that the rate of breach averages one-third,
and the seller's production level, at which contract price equals marginal
cost, is Xk, which is a large number. To maximize profits on sales, seller
needs to enter into enough contracts to produce and deliver Xk units,
which is achieved by entering into 3 / 2xk contracts. We call the problem
of measuring the seller's damages in such cases-cases where breach is
predictable, within limits, on a statistical basis-the problem of statistical
breach.
Such a situation brings out an ambiguity in the meaning of the unin-
jured state (and therefore in the meanings of injury and compensation)
under the expectation conception of damages. Is the uninjured state the
position the seller would have been in if every buyer had performed, or
17. Seller produces until the cost of a marginal unit equals, or almost equals, the contract
price. Since price equals cost, Seller expects no profits on the marginal unit.
18. See infra pp. 1478-80.
19. See id.

the position the seller would have been in if as many buyers performed as
the seller expected? Take the following example:
Example C. Seller operates a limousine service in a major city.
The limousine market is competitive, but on any given day some lim-
ousines may stand idle. Buyer books limousine services from Seller
one month in advance at sixty dollars per hour. When the day
arrives, Buyer's circumstances have changed and he cancels. Limou-
sines are then available for hire from other companies at fifty-five dol-
lars per hour. Seller does a large volume of business and can usually
forecast the number of cancellations that will occur each day. Conse-
quently, he has no unused limousines as a result of Buyer's breach.
Seller sues for breach of contract.
If expectation damages should put Seller at the profit level he would
have attained if as many buyers performed as he expected, then his dam-
ages are nil. If, however, expectation damages should put Seller at the
profit level he would have attained if all buyers performed, then he
should recover. Even though all of Seller's limousines are engaged, he
could have hired a limousine from another company and serviced Buyer
at a profit.
A similar analysis applies to reliance damages. Is the uninjured
state for purposes of reliance damages the situation Seller would have
been in if, instead of contracting with the breaching buyer, he had con-
tracted with no one? Or is it the situation Seller would have been in if he
had contracted with a different buyer? Under the former conception,
reliance damages would be nil. Under the latter conception, damages are
owed, because there is a statistical likelihood that an alternative buyer
would have performed, and Seller could service all performing buyers at
a profit.
In addition to revealing an ambiguity in the meaning of the expecta-
tion and reliance conceptions, the statistical-breach model has fundamen-
tal implications for damages based on lost volume, which are a special
case of lost-surplus damages. For example, several commentators have
argued that lost-volume damages are improper in a perfectly competitive
market. They reason that in such a market, any sale made by the seller
after the buyer's breach is a replacement for the breached contract, so
that the seller will incur no lost volume (and therefore no lost surplus) as
a result of the breach.2" This argument, however, implicitly assumes that
20. The theory is that in a perfectly competitive market a seller will produce only a limited
number of units (based on the point where his marginal cost equals price) and can clear every unit he
produces, so that his volume is the same with or without the breach. See Goetz & Scott, Measuring
Sellers' Damages: The Lost-Profits Puzzle, 31 STAN. L. REv. 323 (1979); Shanker, The Case for a
LiteralReading of UCCSection 2-708(2) (One Profitfor the Reseller), 24 CASE W. Ras. L. REv. 697
(1973); Note, A Theoretical Postscript: Microeconomics and the Lost-Volume Seller, 24 CASE W.
REs. L. REv. 712 (1973).

the seller's business conduct is best described by the traditional model. If

(1) the seller's conduct is best described by the statistical model, (2) the
actual rate of cancellation is higher than the seller anticipated, and (3) he
is unable to clear the excess inventory during the relevant period, then
damages under the expectation principle would be determined by some
variant of the lost-surplus formula.
This is illustrated by a common variation of Example C that occurs
where, as in the case of hotels and airlines, the seller operates in a market
in which the rate of breach by buyers is high, but the seller normally
cannot augment his own capacity in the short run. Sellers in such mar-
kets may routinely overbook orders in the confident anticipation that
some buyers will cancel. If the actual rate of cancellation is the rate at
which the seller overbooked, breach will not disappoint the seller's
expectation or result in unused capacity. If the actual rate of cancella-
tion is lower than the rate at which the seller overbooked, the seller may
be forced to breach some contracts (in which case, each cancellation will
benefit the seller by reducing the number of contracts he himself must
breach). If the actual rate of cancellation is higher than the rate at which
the seller overbooked, breach will cause the seller to have unused capac-
ity and a lower volume than if performance had occurred, and damages
under the expectation principle then would require that some account be
taken of the seller's lost volume.
B. Imperfectly Competitive Markets

1. The TraditionalModel of Business Conduct in Imperfectly
Competitive Markets
Imperfect competition, which exists when some participants in a
market have power over the prices and terms of contracts, often arises
because of product differentiation, geographical segmentation of the mar-
ket, or a large market share for one of the participants. In such a market,
the demand curve faced by a firm is downward-sloping. Since the
demand curve slopes down, a seller who wants to attract more contrac-
tual partners must offer them better terms. Thus, the terms of the con-
tracts that are entered into are more advantageous than the terms of
available alternative contracts. Consequently, the victim of breach is bet-
ter off if there is performance under an actual contract than he would
have been under alternative contracts. In technical terms, the opportu-
nity cost of forgone contracts is less than the expected value of contracts
that are made. The result is that under imperfect competition, expecta-
tion damages exceed reliance damages even under the traditional model.
This point can be illustrated by an adaptation of Example A.
Example D. Buyer wants to purchase a certain kind of boat.

The only person in the region who can supply this kind of boat is
Seller. Buyer and Seller contract for the boat, but on the delivery
date, Buyer tells Seller that he will refuse to accept delivery because a
change in his circumstances has eliminated his need for a boat. Seller
then resells the boat at a reduced price and sues to recover damages
for breach of contract.
In any market, some buyers are more eager than others to make a
purchase, and the most eager buyers are prepared to pay higher prices.
In a competitive market, as in Example A, a seller cannot take advantage
of this fact, since the large number of sellers drives price down to margi-
nal cost. However, in a noncompetitive market, as in Example D, the
seller can take advantage of eager buyers by keeping the price high,
above marginal cost. The customers who are the most eager to buy will
pay the high price, whereas less eager customers will not. Thus Seller in
Example D presumably contracted with Buyer instead of someone else
because Buyer offered more favorable terms to Seller than the best alter-
native offer. Consequently, performance by Buyer is more valuable to
Seller than the opportunity lost by entering the contract, which implies
that expectation damages exceed reliance damages.
The proposition that expectation damages exceed reliance damages
when the injured seller has market power depends upon the fact that the
demand curve faced by the seller is downward-sloping. The downward
slope implies that the seller must lower the price in order to attract more
business, rather than being able to sell as many units as he wishes at the
going price, as in a competitive market. There are many economic mod-
els of market power, such as pure monopoly, oligopoly, and imperfect
competition. Expectation damages normally exceed reliance damages for
all models with a downward-sloping demand curve.
In Figure 4 we have graphed the situation of a noncompetitive
seller. Unlike the competitive case graphed in Figure 3, the demand
curve in Figure 4 slopes downward. The traditional model of an imper-
fectly competitive market explicitly assumes that a seller will supply
commodities until marginal cost equals marginal revenue. This assump-
tion also applies to imperfectly competitive contract markets in which
the probability of breach is low. Seller in Figure 4 maximizes profits by
signing contracts and producing until marginal revenue equals marginal
cost, which occurs at the level of output denoted Xk and the price
denoted Pk.
When Buyer breaches, Seller has extra goods, which he may sell in
the spot market, retain in inventory, or scrap. The decision whether or
not to sell the breached goods turns on whether additional sales will spoil
the spot market. Additional sales spoil the market for a seller if they
lower his profits, whereas an additional sale does not spoil the market if it

Figure 4: Monopolistic Supplier
Price c Marginal Cost
Pk - - - - -
Demand
Marginal Revenue
Xk
Quantity
raises his profits. Since no single supplier can influence the price in a
competitive market, such a market cannot be spoiled by resale of
breached goods. Furthermore, if a seller does not deliberately produce
goods for the spot market, he will not spoil a spot market for himself by
unloading breached goods from time to time. Thus a seller in a competi-
tive market, or a seller who does not deliberately produce for the spot
market, will usually resell breached goods.
In contrast, a sale of breached goods may spoil the spot market if a
seller deliberately produces for an imperfectly competitive spot market.
To illustrate, suppose a seller cannot price-discriminate among buyers, so
that he must charge the same price on goods he deliberately produces for
the spot market and on breached goods he sells there. Assuming that
competition in the spot market is imperfect, the seller may have to lower
the spot price on all goods to attract an additional buyer for the breached
goods. The market is spoiled if the revenue lost by lowering prices on the
goods deliberately produced for the spot market exceeds the revenue
gained by selling the breached goods, whereas the market is not spoiled
when the converse is true.
If resale spoils the market, a seller will respond to breach by with-
holding the breached unit, holding price constant, and reducing his sales
volume. Damages under the expectation principle will then be measured
by the lost-volume formula, together with an offset to reflect the scrap

value of the breached unit. On the other hand, rather than holding price
constant and reducing the volume of sales, the seller may choose to sell
the breached unit, lower the spot price, and hold sales volume constant.
If Seller does resell the breached unit on the spot market, damages under
the expectation principle would be measured by the substitute-price
formula, together with an add-on to reflect the lowered prices on the
units Seller originally produced for the spot market.2 1 Thus the correct
formula for measuring damages under the expectation principle, when
the market is imperfectly competitive and the parties' business conduct is
described by the traditional model, depends on whether the seller
responds to breach by quantity or price adjustments.
The computation of reliance damages under the traditional model of
imperfect competition is similarly complicated. We have already
explained that lowering the price may spoil the market for Seller.2 2 If
Seller had not contracted with Buyer, he might or might not have con-
tracted with someone else, depending on whether an alternative contract
would have spoiled the contract market.2 3 If Seller would have con-
21. Suppose that increasing the supply to the spot market from x s to x, + 1 will cause the spot
price to fall from p, to p. - 1. If Seller cannot discriminate among buyers, the lower price will be
paid by all purchasers on the spot market. Thus, selling the breached commodity on the spot market
will cause Seller to gainps - I from having an additional unit to sell, and to lose x, (p, - 1)
from lowering the price on all units.
22. Assume Seller must charge the same price to every buyer. Therefore, if Seller had not
contracted with Buyer, his choice would have been either to sell xk - 1 units at the high pricepk or
to sell xk units at the low price Pk - 1. For a more complete explanation, see infra note 23.
23. To illustrate the problem, modify Figure 4 as follows. Seller actually signed xk contracts at
the pricepk. Suppose, however, that Seller had not contracted with Buyer. What would Seller have
Price
Pk-1
c Marginal Cost
Demand When Buyer Orders

Demand When Buyer Does Not Order
S Marginal Revenue
Xk- Xk
Quantity
done instead? As depicted in the figure below, eliminating Buyer from the market causes the
demand curve to shift downward. If Seller had wanted to maintain the same price, Pk, in the face of

tracted with an alternative buyer, correct damages under the reliance

principle must take account of this lost opportunity. Consequently, reli-
ance damages would be measured by the opportunity-cost formula, possi-
bly with an add-on if the spot market is spoiled. z4 As a practical matter,
however, in an imperfectly competitive market, determining the value of
the lost opportunity is a difficult counterfactual exercise. If Seller would
not have contracted with an alternative buyer, correct damages under the
reliance principle would be measured by the out-of-pocket-cost formula,
not the opportunity-cost formula, because by hypothesis the seller did
not forgo an opportunity.
2 The Fishing Model of Business Conduct in Imperfectly
Competitive Markets
It has become a generally accepted principle of law that under
appropriate conditions the seller may measure damages by a variant of
the lost-surplus formula that reflects the seller's lost volume.2 5 Use of
this formula has come under a great deal of criticism recently.26 Some of
this criticism seems implicitly to assume that sellers respond to variations
in demand by adjusting prices rather than quantities. As seen in the pre-
ceding Section, the traditional model of business conduct in imperfectly
competitive markets usually (but not always) implies that a seller
responds to breach by lowering his prices sufficiently to attract buyers to
pick up the lost units. In such a case, the seller's volume stays constant,
and his damages would appropriately be measured by the substitute-price
formula. However, rather than conforming to the traditional model of
business conduct, many sellers routinely respond to changes in demand
by holding prices constant and adjusting inventory. When sellers con-
duct their business in this way, correct damages under the expectation
principle would be determined not by the substitute-price formula, but by
the lost-surplus formula, which takes changes in sales volume into
account.
less demand, his sales volume would have fallen by one unit from xk to xk - 1. If instead Seller
wanted to maintain sales at the level Xk, he would have had to lower his price to attract an
alternative buyer. Specifically, if Seller faced the lower demand curve in Figure 4, he would have had
to set the price at Pk - I in order to sell xk units.
Assume Seller must charge the same price to every buyer. Therefore, if Seller had not
contracted with Buyer, his choice would have been either to sell xk - 1 units at the high pricePk or
to sell xk units at the low pricepk - 1. It can be shown that selling an additional unit at the lower
price would have been the more profitable choice if the horizontally shaded area in the figure were
larger than the vertically shaded area, but not otherwise.
24. As with expectation damages, an add-on is required under imperfect competition to reflect
the fact that breach may cause price changes for nonbreached goods.
25. See, eg., Famous Knitwear Corp. v. Drug Fair, Inc., 493 F.2d 251 (4th Cir. 1974); Snyder
v. Herbert Greenbaum & Assocs., Inc., 38 Md. App. 144, 380 A.2d 618 (Md. Ct. Spec. App. 1977);
Neri v. Retail Marine Corp., 30 N.Y.2d 393, 285 N.E.2d 311, 344 N.Y.S.2d 165 (1972).
26. See, eg., the commentary cited supra in note 20.

Example E: Seller supplies branded plumbingware to plumbing

subcontractors under an exclusive territorial franchise. Seller's prac-
tice is to keep in inventory a full line of three colors and selected
models in other colors. If a buyer wants merchandise that Seller does
not have in inventory, Seller orders the models and colors the buyer
wants. Seller always charges the manufacturer's suggested list price.
Buyer places an order for models and colors that Seller does not have
in inventory, but later refuses to accept the merchandise because of
changed conditions in his business. Seller retains the breached items
in inventory and shortly thereafter sells them to someone else at the
list price. Seller sues Buyer for breach of contract.
We call the model that describes business conduct of this type
(Example E) the fishing model, because the seller sets out plumbingware
at a fixed price as bait and fishes for customers.2 7 If one fish gets away
from a fisherman, the rest of the catch is unaffected by the escape; losing
one fish does not enable a fisherman to catch another fish. Similarly, the
effect of Buyer's breach in Example E is the loss of one sale, and that loss
does not make another sale possible.
In Example A and Example B, the seller predetermines his produc-
tion in light of demand in the contract and spot markets. Breach by the
buyer therefore frees for sale in the spot market a unit that would not
otherwise be available. The sale of that unit in the spot market offsets the
loss of volume in the contract market caused by the breach. Accord-
ingly, in Example A and Example B, breach reduces Seller's expected
revenue only by the difference between contract price and spot price, and
expectation damages should be measured by the substitute-price formula.
In contrast, in the fishing model breach reduces the volume of sales in the
contract market without making possible the sale of an additional unit in
either the contract or spot markets. Thus in Example E, Seller expected
to realize a gain on the contract with Buyer equal to the difference
between list price-the contract price-and his cost of supplying the
good. The breach neither enables Seller to enjoy that gain nor makes
possible a sale on the spot market that Seller could not otherwise have
made.2" Damages under the expectation principle, therefore, should be
27. The essentials of the analysis of the type of business conduct described by the fishing
model, and the appropriate conclusions as to damages, see infra text accompanying notes 46-49,
were developed in Eisenberg, The Bargain Principleand Its Limits, 95 HARV. L. REV. 741, 794-98
(1982), but that discussion did not include a formal economic model. Subsequently, Victor
Goldberg put forward an overlapping analysis, and we and Victor Goldberg independently
developed and named the fishing model. See Goldberg, An Economic Analysis of the Lost-Volume
Retail Seller, 57 S. CAL. L. REv. 283 (1984).
28. The case might be different if the second buyer required immediate delivery in just those
models and colors that Buyer ordered, and but for the breach, Seller could not have made immediate
delivery.

measured by the lost-surplus formula. z9
Figure 5: FishingModel
Red Black pkx Total Revenue from

Zone Zone Selling x units at
Price Pk
C = Total Costs of x units
= Co + CIX
Co
x Quantity
XO
Break-Even Point
While Seller's expectation damages are likely to be substantial in

Example E, his reliance damages are likely to be nil. Since Seller sells to
every buyer who is willing to pay the manufacturer's suggested price, he
did not forgo a sale to contract with Buyer. Accordingly, Seller has no
29. This is subject to a possible offset: If Seller's prices remain constant but his variable costs
are rising, Seller's damages should be the lost surplus on the first contract less the increase in cost
between the two contracts. This is because if costs are rising, Seller's costs on the second contract
are less than they would have been if the first contract had been performed. See Goetz & Scott,
supra note 20, at 338-40; Schlosser, Damagesfor the Lost-Volume Seller: Does an Efficient Formula
Already Exist?, 17 U.C.C. L.J. 238, 247-48 (1985). Buyer should therefore be allowed to prove an
increase in Seller's variable costs between the first and second contracts, if he can. See Sebert,
Remedies UnderArticle Two of the Uniform CommercialCode.:An Agenda ForReview, 130 U. PA. L.
REv. 360, 407 (1981). However, in many cases Seller's variable costs will not rise between the first
and second contract because there are no capacity constraints in the relevant range of production or
because there are constant returns to scale. Goetz and Scott also point out another possibility: when
a buyer's circumstances change so that he no longer needs the contractual good, he may accept
delivery and then resell the good. Resale by the performing buyer may spoil the market for the seller
just as if buyer breached and seller resold the good. To be more precise, if (1) a seller regularly
operates in the spot market, (2) the environment is frictionless, so that a buyer can resell purchased
goods in the spot market under the same conditions the seller faces, and (3) there are no costs to the
buyer associated with the resale, then a breach of B units by a buyer produces a corresponding shift
of B units in the demand curve faced by the seller. This point is theoretically sound, but few markets
appear to satisfy the stated conditions.

reliance damages under the opportunity-cost formula. Reliance damages

are also likely to be nil, or very nearly so, under the out-of-pocket-cost
formula.
Seller's situation is graphed in Figure 5. Seller selects a price Pk at
which he will deliver a particular good. The total revenues in any period
from the sale of plumbingware are the price times the quantity, pkX.
Total costs are represented in Figure 5 by the cost curve, C, which
includes both fixed (c0 ) and variable (clx) costs. The intersection of the
total-cost curve and the total-revenue curve, which occurs at sales level
x 0 , separates the profitable and unprofitable regions of sales. If sales are
less than xo, Seller operates in the red in that period; if sales are greater
than xo, Seller operates in the black in that period. Seller cannot foresee
the quantity of sales in any period, but if competitive forces drive profits
to zero, in the long run, the average sales volume will be the break-even
level xo.
Seller's damages from breach are illustrated in Figure 6. During the
Figure 6. Damages in Fishing Model
Xk-l Xk
period when Buyer breached, the total number of contracts signed by

Seller was Xk, but Buyer's breach implies that Xk - 1 buyers performed.

The contract price is set at the level pk, and the marginal cost of plumb-
ingware to Seller is denoted as c. Breach caused Seller to lose profits
Pk - c, indicated by the shaded area in Figure 6.
Before leaving the fishing model, some remarks are in order about
its unconventional aspects. The model appears to capture reality, in that
many sellers hold the price of some goods constant for considerable peri-
ods of time and respond to fluctuations in demand by adjustments in
nonprice elements, such as inventory. For example, most airlines do not
lower prices when a plane is about to depart with empty seats; hotels
seldom lower prices for vacant rooms in the late evening; many clothiers
hold prices constant during the season and then clear inventory by hold-
ing a sale; and many bookstores never lower prices, clearing inventory by
returning books to the publishers. There is no settled theory among
economists to explain these practices. It has been suggested that combin-
ing fixed prices with occasional sales enables a seller to discriminate
among buyers according to their time preferences.3 0 Another explana-
tion is that it is too expensive to reexamine individual prices on a daily
basis, so that rule-of-thumb pricing is adopted over a spectrum of goods
and a period of time. It is also possible that buyers are reluctant to invest
time and energy in shopping at a store where prices change frequently
and unpredictably. Presumably, however, our conclusions about mea-
suring expectation damages would stand whenever a seller holds prices
constant in the face of fluctuations in demand, regardless of his motives.
IV
WHAT MEASURE OF DAMAGES SHOULD THE
LAW PREFER?
A. The General Case

We now consider whether reliance or expectation damages should
be preferred on breach of a bargain contract. In examining this question,
we turn from problems of definition to problems of fairness and policy.
In many cases, the issue of selecting between reliance and expecta-
tion damages is not significant, because the two measures will yield virtu-
ally identical damages. In particular, as shown in Part III, Section A, 3
in a competitive market reliance damages normally will equal expecta-
tion damages unless the seller's business conduct is described by the sta-
tistical-breach model.3 2 While it is true that few markets satisfy all the
conditions of perfect competition, many come close enough so that the
30. Varian, A Model of Sales, 70 AM. ECON. REv. 651 (1980).

31. See supra pp. 1445-49.
32. See supra pp. 1449-51.

difference between expectation and reliance damages would be

insignificant.
The question remains what measure of damages should be used in
cases where expectation and reliance may materially diverge. We begin
our analysis of that question with the concept of efficient contract terms.
Economists often distinguish between efficiency and distribution.
For present purposes, efficiency concerns the amount of value created by
a contract, and distribution concerns the division of that value between
the parties. Economists say that a contract is efficient if its terms maxi-
mize the value that can be created by the contemplated exchange. Put
differently, if a contract is inefficient, revising the inefficient terms can
increase the value it creates.
The distinction between distribution and efficiency parallels a dis-
tinction between the price and nonprice terms of a contract. Adjusting
nonprice terms often makes it possible to control a contract's efficiency.
For example, suppose that our hypothetical contract for a boat includes a
term that imposes very high liquidated damages if Seller breaches. There
are many types of precaution Seller can take to decrease the probability
of breach, such as ordering materials well in advance, hiring extra work-
ers to protect against someone's quitting or falling ill, and reserving dry-
dock facilities needed in the final stages of construction. If the very high
liquidated-damages term is enforceable, it may cause Seller to take exces-
sive precaution, in the sense that the cost of the precaution to Seller is
greater than the value to Buyer of the increased probability that Seller
will perform. In that case, the liquidated damages term is inefficient. If,
however, the term is modified by reducing the liquidated damages, the
saving to Seller from taking less precaution would exceed the cost to
Buyer of exposure to additional risk of nonperformance. This would
result in a net increase in the value created by the contract.
The price term of a contract controls the distribution of the value
that the contract creates.3 3 Revision of an inefficient nonprice term can
produce an increase in value, and this increase can be distributed
between the parties by adjusting the price term so that each party is bet-
ter off. Thus in the boat case, an increase in value from adjusting the
liquidated-damages provision, initially enjoyed by Seller, could be split
with Buyer by lowering the price of the boat. The revised contract, con-
taining lower liquidated damages and a lower price, would make both
parties better off. Put differently, the original contract stipulates dam-
ages in the event of Seller's breach, thus creating a right in Buyer. If
Seller is willing to pay more for a modification of this right than the price
33. An executory price term can influence efficiency in the sense that a buyer's promise to
make a payment in the future affects the seller's reliance. See infra pp. 1465-69.

1985] DAMAGES FOR BREACH OF CONTRACT
Buyer would demand, efficiency requires that the contract be modified.

In this respect, the exchange of legal rights is no different than the
exchange of ordinary commodities.
Under ideal conditions-that is, where negotiation and drafting are
cost-free-self-interest compels a rational buyer and seller to create an
efficient contract, so that the process of bargaining leads to the max-
imization of the value a contract creates. In practice, however, there are
many obstacles to creating efficient contracts. For example, it is costly to
write contract terms. Instead of including explicit terms covering all
contingencies, therefore, most contracts leave many issues to be resolved
by the courts in case an irreconcilable dispute should arise. Specifically,
many contracts leave out terms covering damages for breach, and the
courts, in effect, must fill in the contract with legal damages rules.
The damage rules that the courts apply to fill in contracts should be
both fair and efficient. Contracts negotiated under ideal conditions will
be efficient, and enforcing the terms of such contracts will usually be
regarded as fair. Thus we take as a theorem that a damage rule is both
fair and efficient if it corresponds to the terms that rational parties situ-
ated like the contracting parties would have reached when bargaining
under ideal conditions.
The question then is, why might rational parties, who address the
issue, choose an expectation measure over a reliance measure? One rea-
son is administrative: it is usually easier to establish in court the value of
performance than the extent of reliance. The very fact of reliance is often
difficult to prove, as in cases where the reliance consists of passive inac-
tion (such as failure to pursue alternatives) rather than a positive change
of position. Even if the fact of reliance can be proved, reliance damages
may be difficult to measure. In a noncompetitive market, for example,
reliance damages would normally be calculated by the opportunity-cost
formula, which requires determining the forgone price. Often, however,
the forgone price is very hard to determine, as where the commodity is so
unusual that there is no way to establish exactly what the next-best alter-
native buyer would have paid. In contrast, expectation damages are
based on the contract price, which is known, rather than the forgone
price, which is speculative. This administrative consideration has impli-
cations for both fairness and efficiency. In terms of fairness, the difficulty
of proving reliance damages might, paradoxically, result in a failure to
protect the reliance interest unless an expectation measure is chosen. In
terms of efficiency, a damage measure that was difficult to prove, and
therefore unreliable, would undercut the goal of facilitating private
planning.
An intimately related set of considerations has to do with the incen-

tive effects of the expectation and reliance measures.3 4 Most contracts

are made with the expectation of mutual gain. As shown in Part I, this
gain can be measured by the profits created for firms or the consumer's
surplus created for individuals.35 The total gain to both parties-the sur-
plus from exchange-is the value created by the contract. The terms of a
contract have incentive effects upon behavior that influence how much
value the contract will create.3 6 Accordingly, one index to whether a
damage rule would have been agreed to by rational parties situated like
the contracting parties, and bargaining under ideal conditions, is whether
the rule provides incentives for efficient behavior.
Contract damage rules influence several types of behavior, such as
searching for trading partners, negotiating exchanges, drafting contracts,
keeping or breaking promises, relying upon promises, mitigating dam-
ages caused by broken promises, and resolving disputes about broken
promises. A complete account of the incentive effects of various damage
rules would model the effects on all these types of behavior. Instead of
aiming for completeness, we will focus on incentives to perform
con-
37
tracts, to take precautions against breach, and to rely on contracts. To
illustrate, in our boat example Seller must decide whether to perform,
and how much precaution to take to assure that he will be able to per-
form, and Buyer must decide how much to rely on Seller's promise (e.g.,
whether to make a contract for dock space to begin when the boat is
scheduled to be delivered). These three decisions concern the rate of
breach, the amount of precaution, and the extent of reliance.
L Performance
We begin with the incentive effects of damage measures on the deci-
34. For a comparison of incentive effects of damage rules, see Shavell, Damage Measuresfor
Breach of Contract, 11 BELL J. ECoN. 466 (1980).
35. See supra pp. 1435-38.
36. We assume here that the incentive effects of contract law are significant over a broad range
of cases. The importance of such effects has been questioned. For example, Kornhauser
distinguishes "perfect reputation" from "anonymity" in the contractual setting. As information
concerning reputation improves, the incentive effects of contract law may diminish. See
Kornhauser, Reliance, Reputation, and Breach of Contract, 26 J.L. & EON. 691 (1983). But cf
Eisenberg, supra note 20, at 744 n.8 (data concerning reputation is so difficult to assemble that a
regime dependent solely on reputation would almost certainly be less fair and efficient than an
enforcement regime). In any event, express and even implied contractual provisions would have
incentive effects under a reputation regime, since they would be controlling in determining whether
breach had occurred. Cooter and Landa demonstrate that formal contract law substitutes for
informal enforcement mechanisms, such as clubs or religious organizations that impose sanctions on
members who breach contracts. As formal contract law improves, the optimal size of these club-like
arrangements diminishes. See Cooter & Landa, Personal Versus Impersonal Trade: The Trading
Groups and Contract Law, 4 IN'L REv. L. & ECON. 15 (1984).
37. Following the economic convention, we focus upon incentives for behavior, rather than
arguments about risk-spreading. For a very useful discussion of risk-spreading, see Polinsky, Risk
Sharing Through Breach of Contract Remedies, 12 J. LEGAL STUD. 427 (1983).

sion whether to perform, that is, on the rate of breach. A contract

involves a promise by at least one party, and it is always possible that
events will induce a promisor to refuse to perform, either because per-
formance has become unprofitable or because an alternative performance
has become more profitable. If a promisor were liable only for the prom-
isee's reliance damages, the value of the promisor's performance to the
promisee would not enter into a purely self-interested calculation by the
promisor whether to perform. In contrast, expectation damages place on
the promisor the promisee's loss of his share of the contract's value in the
event of breach, and thereby sweep that loss into the promisor's calculus
of self-interest.
The effect of expectation damages on the promisor's calculations can
be stated in terms of externalities. Economists say that an externality
exists when one person imposes a cost upon another without paying for
it. Incentives for performance are efficient if they compel a promisor to
balance the cost to him of performing against the losses to himself and to
others that will result if he does not perform. If the promisor does not
perform, the promisee loses his share of the value of the contract. If the
promisor is liable for that loss, he internalizes not only his own loss but
the losses to the promisee that result from his failure to perform. In
contrast, if the promisor is liable only for reliance damages, he will not
internalize the full value of performance to the promisee. Thus expecta-
tion damages create efficient incentives for the promisor's performance,
while reliance damages do not, unless they are identical to expectation
damages.
By directly affecting the probability that the promisor will perform,
the expectation measure has an indirect effect upon the promisee's behav-
ior, which can be stated in terms of planning. Knowing that expectation
damages give the promisor strong incentives to perform, the promisee
will be more confident that his reliance on the promisor will not expose
him to undue risk. The promisee can therefore plan more effectively,
because once a contract is made he can order his affairs with the confi-
dence that he will realize its value, whether by performance or damages.
In contrast, under a regime of reliance damages, a promisee could plan
only on the basis that if breach occurs the law will put him back to where
he was when he started. Since planning is by nature forward-looking,
this backward-looking nature of reliance damages would be a shaky
foundation for ordering complex affairs. Furthermore, it is in the prom-
isor's interest that the promisee be able to plan reliably, because the abil-
ity to do so will make the promisee willing to pay a higher price for the
promise.
These ideas can also be expressed in institutional terms. The pur-
pose of the social institution of bargain is to create joint value through

exchange. In recognition of the desirability of creating value in this man-

ner, the legal institution of contract supports the social institution of the
bargain with official sanctions. It is rational to design the legal sanctions
so that the joint value from exchange is maximized. This goal is achieved
by protecting the expectation interest.
2. Precaution
One reason breach may occur is that the contract has become
unprofitable to the promisor due to an increase in his cost of perform-
ance. Another reason is that circumstances have changed so that per-
formance has become impracticable, although there is no legal excuse for
nonperformance. In either case, the promisor might have forestalled the
motivation for breach if he had taken appropriate precautions against the
change in cost or circumstances. In the boat case, for example, Seller
could have ordered materials well in advance to avoid a price rise, hired
extra workers to protect against someone quitting or falling ill, and
reserved drydock facilities necessary for the final stages of construction
to ensure their availability when needed. Precaution is usually costly in
terms of money, time, or effort. From an efficiency standpoint, however,
this cost must be balanced against the resulting benefits-a reduction in
the probability of breach, and a consequent enhancement of the likeli-
hood that the value of the contract will be realized.
The argument that expectation damages provide incentives for the
efficient amount of precaution is the same as the argument that expecta-
tion damages provide incentives for the efficient rate of performance.
Incentives for precaution are efficient if they compel the promisor to bal-
ance the cost of his precaution against the cost of failing to take precau-
tion, including the risk to the promisee of losing his share of the
contract's value. In the absence of liability for the promisee's expectation
damages, the latter cost would not enter into a purely self-interested cal-
culation by the promisor, and the promisor's incentive for precaution
would therefore be inadequate. By placing on the promisor the prom-
isee's risk of losing his share of the contract's value in the event of
breach, that risk can be swept into the promisor's calculus of self-interest.
Expectation damages, which make the promisor liable for the promisee's
loss of value caused by the breach, therefore cause the promisor to inter-
nalize the cost of his failure to take adequate precaution, facilitate plan-
ning by the promisee, and create incentives for efficient precaution
against breach. Reliance damages, which are not based on the value of
the contract to the promisee, do not create efficient incentives for precau-
tion except where they equal expectation damages."8
38. It is interesting to note that the structure of the incentive problem concerning precaution
against breach is similar to the structure of the incentive problem concerning precaution against

3. Reliance
Once a contract has been made, a party may take various actions in
reliance upon it. Some such actions fall into the category of performance
or preparation for performance. For all practical purposes, these actions
are not within the contracting party's discretion. The very purpose of
the contract is to commit the party to perform and, by implication, to do
whatever is necessary to prepare for performance. If one party does not
perform, he is in breach and unable to establish rights against his con-
tracting partner.
There is, however, another category of reliance whose nature or
extent is discretionary. The most important component of this category
consists of reliance that is neither explicitly nor implicitly required under
the contract, although it will enable the relying party to benefit more
from the contract. In the boat case, for example, Buyer might buy spe-
cial navigational equipment in advance so that he can take transoceanic
trips as soon as the boat is delivered, rather than postponing his enjoy-
ment of such travel by awaiting delivery of the boat before ordering the
special equipment. We will use the term "surplus-enhancing reliance" to
refer to discretionary reliance by a contracting party that is undertaken
to increase the surplus over and above what he would enjoy had he sim-
ply done what was explicitly or implicitly required under the contract.
Typically, surplus-enhancing reliance increases not only the surplus
from performance of the contract, but also the loss that will result if the
promisor breaches. For example, if Seller in the boat case breaches,
Buyer might have to sell the special navigational equipment at a loss.
Economists say that a gamble gets more risky as the spread in value
between winning and losing increases. More risk involves the possibility
of a larger gain and the possibility of a larger loss. Reliance that will
enhance the surplus from a contract usually increases the risk involved in
a contract.
In the preceding Sections39 we argued that the rate of breach and
the extent of precaution by the promisor are efficient under a regime of
expectation damages. The effect of a damages regime on surplus-enhanc-
ing reliance is more complex. A rule placing all the costs of such reliance
on the promisor might be thought desirable on the ground that it would
allow the promisee to plan as if the contract will be performed. On the
other hand, we know that not all contracts are performed. Indeed, some-
times both parties can be made better off by nonperformance. It can
accidents in tort. In torts, incentives for precaution are efficient when the injurer is liable for the full
harm caused by accidents, just as in contracts incentives for precaution by the promisor are efficient
when the promisor is liable for the full harm caused by breach. See Cooter, Unity in Torts,
Contracts, and Property: The Model of Precaution, 73 CALIF. L. Rav. 1 (1985).
39. See supra pp. 1462-64.

therefore be argued that it is efficient for a promisee to engage in surplus-

enhancing reliance only to the extent that such reliance is profitable given
the probability of nonperformance.
Assume, for example, that Lessor agrees to lease commercial prem-
ises to Lessee for a new retail store, beginning on July 1. To maximize
the value of the contract, Lessee may take various steps in reliance prior
to July 1, such as advertising the opening of the store. If it is certain that
Lessor will deliver the premises on time, Lessee will make advertising
expenditures up to the point where one more dollar of expense will pro-
duce one more dollar of profit. Assume the level of surplus-enhancing
reliance under this state of the world is X dollars. Now suppose that
Lessee realizes there is a given probability of nonperformance by Lessor,
sayp. On the assumption thatp is not zero, the efficient level of reliance,
which maximizes the expected value of the contract, is less than X dol-
lars. Presumably, therefore, Lessee should factor the probability p into
his calculations and spend less than X dollars for advertising. Corre-
spondingly, if a damage measure creates incentives for Lessee to spend X
dollars, the measure may be thought to create an incentive for inefficient
behavior. We will use the term overreliance to refer to reliance that is
inefficient in this sense.
The potential for inefficient overreliance should not be overempha-
sized, because it is limited to forms of reliance that increase the benefit
and risk associated with the contract. Thus the possibility of overre-
liance often is not salient in the case of sellers. Typically, a seller's reli-
ance consists solely of preparing to perform and performing, and its
discretion involves forms of precaution, such as scheduling. Overreliance
also is typically not a salient problem for buyers in the case of contracts
for homogenous commodities that are readily available on a competitive
market. It is usually efficient for a buyer of such commodities to rely as if
the seller's performance were certain, because even if the seller does
breach, the buyer can normally replace the breached item with an identi-
cal commodity on the market, and thereby put his reliance to full use.
For present purposes, however, the important point is not the precise
extent of the problem, but that a potential for overreliance can exist.
Both the reliance and the expectation measures might be interpreted
to require a breaching promisor to compensate the promisee for all of the
promisee's actual reliance, whether efficient or not. For example, the
Lessee in the hypothetical might be allowed to recover all of his advertis-
ing costs under a reliance measure, on the theory that the costs were
incurred in reliance and now have gone to waste. He might be allowed to
recover all of his advertising costs under an expectation measure, on the
theory that if Lessor had performed, Lessee not only would have cap-
tured his expected net profit, but also would have recouped his advertis-

ing costs. Such interpretations would create incentives for overreliance,

because the promisee's expenditures on advertising would, in effect, be
insured by the promisor.
The problem can be avoided, however, if the reliance and expecta-
tion measures are interpreted to provide for invariant damages with
respect to reliance. A measure of damages is invariant with respect to
reliance if the promisee cannot increase the promisor's liability by addi-
tional reliance over a given baseline. Under those conditions, the prom-
isee internalizes the risk of reliance over the baseline, so that the damage
measure will not in itself cause him to overrely. A familiar example is
provided by liquidated damages. To illustrate, suppose that in the retail-
store hypothetical, the lease validly specified that Lessor would pay $500
per week for late completion, up to a maximum of $8,000. The damages
that Lessee could recover on Lessor's breach would then be unaffected by
the extent of Lessee's advertising or other surplus-enhancing reliance.
Thus the liquidation of damages makes damages invariant with respect
to reliance.
Similarly, the reliance and expectation measures can be interpreted
as invariant with respect to reliance by limiting recovery on the basis of
reliance to costs that are reasonably incurred. Such an interpretation
would make the two measures invariant, because reasonability is an
objective test. Under this test, therefore, actual reliance in excess of rea-
sonable reliance would not be compensated, and the risk of reliance
above the reasonability baseline would be internalized by the promisee.
If the reasonability baseline was set at the level of efficient reliance, then
overreliance would be uncompensated and the promisee would bear its
full cost.
Arguably, such an interpretation already prevails under existing
law. Both the expectation and reliance measures undoubtedly contem-
plate that only reasonable reliance will be compensated. The question for
present purposes is what kinds of factors determine reasonability. If eco-
nomic analysis suggests that it is inefficient to engage in surplus-enhanc-
ing reliance without regard to the likelihood of breach, that analysis can
be read into the meaning of reasonability. Accordingly, although either
the expectation or the reliance measure can be interpreted in a way that
might create incentives for overreliance in some cases, there is nothing in
the nature of these measures that requires such an interpretation, and
there is good reason for interpreting them in a manner that would not
give rise to overreliance. Under such an interpretation, both the expecta-
tion and the reliance measures would lead to an efficient level of
reliance.'
40. Having discussed incentives for performance, precaution, and reliance, we consider briefly
the problem of the efficient number of contracts. It is well known that the quantity of goods

In short, where expectation and reliance damages diverge, expecta-

tion damages are preferable because they better assure that reliance will
be compensated, better facilitate planning, provide better incentives for
efficient performance and precaution, and provide no worse incentives
for overreliance.
B. The Limits of the Expectation Principle

In the preceding Section, we showed why expectation damages are
normally fair and efficient. In this Section, we shall discuss a special
problem with expectation damages that arises when a seller's business
conduct corresponds to our fishing or statistical-breach models.
In analyzing this problem, we shall return to the theorem that a
contract term can be deemed both fair and efficient if it corresponds to
the term that rational parties would probably have agreed to if they had
bargained under ideal conditions (that is, if negotiation and drafting were
cost-free). Based on this theorem, we shall distinguish between the
expectation principle and what we shall call the expectation theory. The
expectation theory-which follows from the theorem-is that in case of
breach the injured party's recovery should be measured under the dam-
age rule the parties probably would have agreed to at the time of con-
tract-formation if they had bargained under ideal conditions and had
addressed the issue. The expectation principle-which is a doctrinal
principle of contract law-is that in case of breach the injured party
should be put in a position as good as he would have enjoyed had the
contract been performed. The principle gives fair expression to the the-
ory in most but not all cases.
exchanged in a perfectly competitive market is efficient. Efficiency is achieved because exchange

occurs until each buyer values an additional good at its cost to the seller. Similarly, contracts will be
exchanged in a perfectly competitive market until each buyer values the marginal contract at the
cost to the seller, so the number of contracts will be efficient. In contrast, a nondiscriminating
monopolist will overprice goods, with the result that fewer than the efficient number of goods are
exchanged. Similarly, the price of contracts supplied by a nondiscriminating monopolist will be too
high, with the result that too few contracts are made for an efficient level of contracting.
We have already shown that expectation damages usually provide efficient incentives for
performance, precaution against breach, and reliance, and that this is true in competitive and
noncompetitive markets. What about incentives to supply the efficient number of contracts in
noncompetitive markets? Here the policy question may seem simple: since too few contracts are
usually supplied under conditions of monopoly, where those conditions prevail the superior damage
measure from the viewpoint of the number of contracts is the measure that results in the proper
number of contracts. However, the administrative difficulties of determining whether a seller is a
monopolist, and what damages will result in the proper number of contracts, make those issues
unsuitable for case-by-case determination in contract law cases. Furthermore, it may be that a
monopolist will set a monopoly price, but stipulate damage terms so as to maximize the surplus from
exchange. In other words, monopoly contracts might be characterized by inefficient price and
efficient nonprice terms. The technical analysis of that issue is complicated, and we have no simple
generalizations to offer. This ambiguous conclusion is predictable, since we are discussing a
"second-best" situation in which economic analysis often proves inconclusive.

We begin with the fishing model. Here the seller supplies commodi-
ties to all buyers at a fixed price, so that breach causes a reduction in
sales volume. At least at first glance, the lost-surplus formula-and
more particularly, the "lost-volume" measure of damages-is necessary
to compensate for this reduction in volume. However, there has been
much controversy in secondary literature concerning the propriety of
lost-volume damages in such circumstances."a Whether expectation
damages are appropriate when the injured party's method of doing busi-
ness is best described by the fishing model or by the statistical-planning
model, and if so, how to correctly measure the seller's expectation, are
difficult questions, to which we now turn.
Prior to the adoption of the Uniform Commercial Code, a seller's
measure of damages for breach of a contract for the sale of goods was
governed by the Uniform Sales Act. That Act provided that if there was
an available market for the goods, the seller's damages normally were to
be measured by the difference between the market price and the contract
price.4 2 In contrast, section 2-708(2) of the U.C.C. provides that if the
difference between contract price and market price is inadequate to put
the seller in as good a position as performance would have done, the
seller's damages are to be measured by the profit, "including reasonable
overhead," that he would have made from the buyer's full performance.
The case law holds that this alternative measure is to be used when the
seller conducts his business in such a manner that the breach did not
enable him to make a substitute sale (a sale he would not otherwise have
made), so that as a result of the breach the seller loses volume.4 3 To put
the matter in terms of the analysis in this Article, the Uniform Sales Act
provided that in a contract for the sale of goods the seller was normally
entitled only to substitute-price damages. In contrast, the U.C.C. pro-
vides that the seller can recover lost-surplus damages when appropriate.
The case law holds that lost-surplus damages are appropriate when the
seller's method of doing business is best described by the fishing model.
The routine award of lost-surplus damages for the buyer's breach of
a contract for the sale of goods is a relatively recent phenomenon. Such
damages have long been routinely awarded, however, for the buyer's
breach of a contract for the provision of services.' Consider, for exam-
ple, the following illustration:
Example F: B, a manufacturer, wants to have an office building
constructed for its headquarters on property it owns. S, a contractor,
agrees to construct the building for $5 million. S's projected out-of-
41. See articles cited supra notes 20, 27 & 29.

42. UNIFORM SALES AcT § 64 (act withdrawn 1951).
43. See, eg., cases cited supra note 25.
44. See, e-g., RESTATEMENT OF CONTRAS § 346(2)(a) (1932).

pocket cost of construction is $4.3 million. The contract is entered

into on May 1, 1983; construction is to begin on August 1, 1983, and
to be completed on May 1, 1984. Payment is to be made in install-
ments as the building progresses. On July 15, 1983, B repudiates the
contract.
The fairness and efficiency grounds adduced in Part IV, Section A4 5
to justify expectation damages also support the award of expectation
damages in general, and lost-surplus damages in particular, in cases like
Example F. A contractor's capacity to take on jobs normally is con-
strained by such factors as bonding limits and depth of management.
Ordinarily, a contractor will attempt to take on as many jobs as it can
within the limit of these constraints. Accordingly, it is likely that by
virtue of making the breached contract, the contractor will have forgone
the opportunity to make another contract, which would have yielded its
own surplus. The contractor is also likely to incur other opportunity
costs, such as allocating executive time to planning or performing the
contract. Fairness normally requires that a victim of breach at least be
compensated for his costs, including his opportunity costs. However, it
would often be very difficult for the contractor to quantify his opportu-
nity costs and prove them in court. It may be difficult for the contractor
to establish that an opportunity to make another contract was forgone, if
only because, having made the breached contract, he stopped searching
for other opportunities. The allocation of executives' time to a project,
and the related planning costs, are also difficult to establish. Because of
these difficulties, a reliance measure would be unpredictable in its appli-
cation. Unpredictability of application is an obstacle both to protecting
the contractor's reliance interest, as required for fairness, and to reliable
planning, as required for efficiency. In addition, expectation damages
make the buyer internalize the benefits of the contract to the parties, and
thereby provide him with efficient incentives in making decisions con-
cerning performance and precaution, and further assure reliability in
planning.
The same reasoning supports measuring the contractor's expectation
by the lost-surplus formula. In theory, the substitute-price formula
might be used in such cases, if the contractor completed construction of
the building and sold it to an alternative buyer. In practice, when the
buyer breaches, the contractor usually must abandon the project, because
normally the construction is to occur on the buyer's land, or it is tailored
expressly for the buyer, or completion would violate the principle of miti-
gation of damages or expose the contractor to undue business risks. Fur-
thermore, lost-surplus damages, and not substitute-price damages, will
45. See supra pp. 1459-68.

cause the buyer to internalize the full benefits of the contract to the con-
tractor, and thereby assure reliable planning and provide the buyer with
the correct efficiency incentives in making decisions concerning perform-
ance and precaution. Thus the lost-surplus formula normally will be the
appropriate formula to measure expectation damages in cases like Exam-
ple F.
The analysis applied to Example F can be extended to most con-
tracts involving the provision of services to merchant-buyers. It may also
be extended in substantial part to contracts for the sale of goods to a
merchant-buyer by a seller whose method of doing business is best
described by the fishing model (as in Example E). The analysis may
break down, however, where the buyer is a consumer of nonindividual-
ized or "off-the-shelf" services, as in the following example:
Example G: Seller owns a dancing school. He sets a fee of $300
for each 20-session class, and allows preenrollment when accompa-
nied by a down payment of $30. Seller's teachers are on contract,
and the building in which classes are conducted is held under a long-
term lease, so Seller's out-of-pocket cost for conducting any given
class is virtually nil. Buyer preenrolls on May 1 for a class beginning
on July 1. By May 20, Buyer's circumstances have changed, and he
cancels. The class was undersubscribed, so Buyer's enrollment did
not preclude Seller from contracting with another student, and
Buyer's cancellation did not enable Seller to enroll a student who
would not otherwise have been enrolled. Seller now sues Buyer to
recover $270, the difference (calculated under the lost-surplus
formula) between the profits it would have earned if the Buyer per-
formed, and the profits it will actually earn given Buyer's
cancellation.
If Seller can recover $270, Buyer will have paid the full $300 con-
tract price to Seller although he has received no lessons. Such a recovery
would not be easy to justify on the ground that the expectation measure
is required to protect the reliance interest in a bargain context. By
hypothesis, Seller has incurred neither out-of-pocket nor opportunity
costs. Would such a recovery be justified by considerations of efficiency?
In Part IV, Section A, we argued that a damage rule should cause a
promisor to internalize the value of the contract, so as to provide incen-
tives for efficient rate of breach and efficient precaution.' This argument
applies to Example G, but there is a broader set of efficiency considera-
tions that must be discussed to reach a satisfactory conclusion.
To begin the broader analysis, recall first the theorem that a con-
tract term can be deemed both fair and efficient if it corresponds to the
46. See supra pp. 1459-68.

term that rational parties situated like the contracting parties would
probably have agreed to if they were bargaining under ideal conditions.
Recall next the expectation theory, which follows from this theorem:
expectation damages should be based on the measure that rational parties
situated like the contracting parties would probably have agreed to if
they had bargained under ideal conditions and addressed the issue. In
analyzing whether the parties in Example G would probably have agreed
that if Buyer breached, Seller's damages would be measured by its lost
surplus, the relevant question is why someone in Buyer's position would
make a contract on May 1, rather than simply wait until July 1 and
enroll on the first day of class. Consumers normally do not make con-
tracts like that in Example G for the purpose of allocating the risk of
price changes, or speculating in the market for dancing lessons. Rather,
the typical purposes of such contracting are to ensure supply (that is, to
ensure a place in the class) and, perhaps, to commit oneself to an action.
Given these purposes, it seems unlikely that Buyer would have
agreed ex ante to a provision that if he cancelled in advance he would pay
the entire tuition. In effect, such a provision would allocate to Buyer all
the risks entailed by his change of mind. Buyer would be unlikely to
accept such a risk allocation, because it would be greatly disproportion-
ate to both the benefit to be derived (which is not the dancing lesson
itself, but the reservation of a place in line and the personal commit-
ment), and the harm inflicted on Seller in terms of how much worse off
he is as a result of having made the contract. Seller, for its part, would
not be likely to insist on such a risk allocation, because (a) if he did so he
would diminish his profitability, since too few consumers would sign con-
tracts; (b) it would be unnecessary to do so, in light of the relatively low
degree of harm he will suffer; and (c) as we shall show, Seller could util-
ize other mechanisms that would address his needs at significantly less
cost (and therefore greater acceptability) to Buyer than lost-surplus
damages. 47
Are lost-surplus damages required to provide the correct incentives
to Buyer for performance and precaution? Since these efficiency consid-
erations concern incentives, they are premised on the assumption that the
parties know how damages will be measured, or that the damage mea-
sure used by the courts corresponds to the measure the parties had rea-
47. If Seller had been operating at full capacity, and reserved a place for a Buyer, he may have
turned away an alternative customer. If Buyer's place was not eventually filled, Seller will have
incurred an opportunity cost equal to the contract price. One way to handle this problem is to
permit Seller to recover his lost surplus in such a case under a reliance theory, with the burden on
Seller to prove both that he was operating at full capacity and that he turned away another customer
because of his contract with Buyer. However, if Buyer would probably not have agreed to lost-
surplus damages ex ante, recovery of lost surplus might be inappropriate even on a reliance theory,
unless the parties contracted to that effect.

son to expect the courts would use or corresponds to a term the parties
probably would have agreed to if they had bargained under ideal condi-
tions and addressed the issue. Measuring damages by a given formula
cannot affect a party's incentives if he does not know, have reason to
expect, or probably would have agreed that damages will be measured by
that formula. Given Buyer's purposes for entering into the contract, his
consumer status, and the likelihood that he would not have agreed ex
ante to a lost-surplus formula, it is hard to imagine that Buyer would
have known or reasonably expected that damages would be measured
this way by the courts.
Are lost-surplus damages justified on the grounds that they are nec-
essary to enable Seller to plan effectively? Although firm proof is lacking,
the available evidence tends to suggest that firms selling services to con-
sumers can and do plan effectively without expecting to collect damages
measured under the lost-surplus formula. For example, the problem
raised by Example G is characteristic of any contract for tuition, and
such contracts often involve relatively large amounts. Nevertheless,
many and perhaps most schools provide for refunding tuition on a
declining basis if the student drops out.
The lack of a planning justification for lost-surplus damages is par-
ticularly clear in the case of a seller whose method of doing business is
accurately described by the statistical-planning model. By hypothesis,
such a seller does not make plans on the basis that any particular con-
tract will be kept. If the seller's statistical forecast is reasonably accurate,
his planning is therefore not interrupted by any single breach, or even by
a number of breaches. Indeed, if the seller's forecast is correct, he may
be said to realize his ex ante expectation in spite of breach. Such a seller
therefore can plan reliably even if his damages are not measured by the
lost-surplus formula.
Accordingly, in contracts for off-the-shelf services to be provided to
a consumer, lost-surplus damages normally are not required by either
efficiency or fairness considerations, particularly where the statistical-
planning model is applicable. Rather, damages in such cases should be
based on the amount necessary to (a) reimburse the seller for incidental
costs, (b) provide enough deterrence to facilitate planning, and (c) pay
for the buyer's benefit in having had a place reserved. A formula that
reflects these three elements would probably be the formula the parties
would have agreed to ex ante had they addressed the issue and bargained
under ideal conditions.
The measurement required need not be difficult. In most cases, the
law could treat a deposit by the buyer as a tacit liquidated-damages pro-
vision even if the contract does not so provide. It seems likely that most
consumers expect that if they cancel a contract for off-the-shelf services

they will lose their deposit (whether or not the contract so provides) but
nothing more.4" Setting damages equivalent to either an explicit liqui-
dated damages clause or the amount of any deposit therefore would sat-
isfy the expectation theory, unless the buyer was not aware of the
liquidated-damages clause or the amount of the deposit was clearly in
excess of what the buyer would probably have expected to forfeit on can-
cellation.4 9 In cases where the seller neither includes a liquidated-dam-
ages provision nor requires a deposit, the law might limit damages to
reliance or to the substitute-price formula, or might impose a charge
based on the customary level of deposits required in the relevant indus-
try, on the ground that this practice shows what similarly situated sellers
and buyers would agree to under like circumstances.
Expectation damages measured in this way might be denominated
"cancellation-charge damages." The manner in which such damages
should operate can be illustrated by the airline business. The airlines'
overbooking system is an application of the statistical-planning model of
doing business. By use of this system, airlines can make reliable plans
even without requiring no-show passengers to pay lost-surplus damages
(which would be almost equal to the entire cost of the ticket if a plane
has vacant seats, since there is almost no out-of-pocket cost for carrying
one additional passenger). On the other hand, if passengers can make
multiple bookings without cost, they may have an incentive to do so,
thereby increasing the airlines' costs and making it more expensive for
the airlines to compile and administer their forecasts. However, a rea-
sonable cancellation charge would normally be sufficient to induce a pas-
senger not to engage in multiple bookings, because if he does so he will
end up paying more than the cost of the ticket for his flight. Accord-
ingly, airlines characteristically do not attempt to collect lost-surplus
damages, but do sometimes impose cancellation charges.
Let us now apply this analysis to the sale of relatively homogeneous
goods by a merchant to a consumer, as in the following hypothetical:
Example H: Buyer, a high school teacher, wants to buy a new
Buick. After shopping around, Buyer decides to buy at Seller's deal-
ership, since Seller's price matches the lowest price available from
competing dealers and Seller has a good reputation for servicing. On
October 1, Buyer signs a contract to buy from Seller a new Buick,
with specified accessories, for $10,000, delivery on December 1.
48. See Eisenberg, supra note 27, at 794-98.

49. U.C.C. § 2-718 would be relevant here. That section provides that if a contract for the sale
of goods is breached by the buyer, the buyer is entitled to recover any amount by which his payments
before breach exceeds (1) the damages set in a valid liquidated-damages provision, or, if there is no
such provision, (2) 20% of the contract price $500, whichever is less, subject to an offset in the
amount of the seller's damages and of benefits received by the buyer.

Buyer puts down a deposit of $250. On November 1, before the fac-

tory has begun to fill Seller's order for Buyer's car, Buyer repudiates
the contract. Seller's factory cost for the Buick ordered by Buyer is
$8,500, and Seller can buy as many new Buicks from the factory as it
sells.
Much the same analysis can be made in this kind of case as in
Example G. Under the lost-surplus formula, Seller would recover $1500.
This result is not as draconian as the application of that formula in cases
like Example G. Seller's projected out-of-pocket cost is significant, and
the recovery therefore would be well below the entire amount of the con-
tract price. Nevertheless, the result is not easy to justify on the theory
that lost-surplus damages are required to protect the reliance interest,
since Seller will have incurred little or no cost at the time of the breach.
Similarly, it is unlikely that Buyer would have agreed ex ante to a provi-
sion measuring damages for cancellation in this manner. It is unlikely
too that lost-surplus damages are necessary to provide Buyer with the
correct incentives for efficient behavior, because Buyer probably believes
that at worst he will lose his deposit. Finally, it is unlikely that lost-
surplus damages are required to enable Seller to plan effectively, since
Seller is likely to use a combination of the statistical-planning model and
deposits to deal with the problem of breach. Indeed, casual investigation
suggests that few mass retailers-including few new-car dealerships-
bring suits for breach of executory contracts. Accordingly, Seller's dam-
ages should be limited to the deposit.
CONCLUSION
Fairness seems to require that a person who breaches a contract

should pay compensation to the victim of breach for the injury he suffers
as a result. But the meanings of the terms "compensation" and "injury"
are fundamentally ambiguous. Under a reliance conception, the unin-
jured state is the condition the victim would have been in if he had not
made the contract with the breaching party. Under an expectation con-
ception, the uninjured state is the condition the victim would have been
in if the breaching party had performed the contract. Which conception
should govern is far from obvious.
Under certain conditions, it is unnecessary to choose between these
two conceptions. In perfectly competitive markets where the rate of
breach is low and the seller's business conduct is described by the tradi-
tional economic model, expectation and reliance damages will be virtu-
ally equivalent. This equivalence also will hold in imperfectly
competitive markets, if market conditions do not vary materially from
those of perfect competition and the seller's business conduct conforms
to the traditional model applicable to these markets.

Often, however, the two measures may diverge significantly. This

may occur, for example, in imperfectly competitive markets whose con-
ditions differ materially from those of perfectly competitive markets, or
in which the seller's business conduct is best characterized by the fishing
model. The question of choice between competing conceptions of injury
and compensation then becomes material. Traditionally, courts and
commentators were united in holding that the expectation conception of
injury governed in such cases. In fact, prior to the 1930's the reliance
principle operated in only a covert manner. However, with the promul-
gation in 1932 of section 90 of the Restatement of Contracts, 5 0 and the
publication in 1934 of Fuller and Perdue's landmark article The Reliance
Interest in ContractDamages,51 the reliance principle began to undergo a
process of steady and impressive growth. Until the last ten years or so,
this growth served to expand liability in contract. Recently, however,
some commentators have taken the position that the reliance principle
should be used to reduce liability, by substituting the reliance conception
for the expectation conception in the law of damages.5 2
The reasons for this position are complex. Partly it is an attack on
the very institution of contract: liability based on reliance may be con-
ceptualized as liability in tort. It also results, however, from the appar-
ent lack of a clear rationale for expectation damages. The reliance
conception of injury reflects the basic intuition that if somebody is worse
off than he was before, he has been hurt. The expectation conception
reflects a much more subtle intuition, and indeed it is plausible to argue
that the mere defeat of an expectation is not a very serious injury.
One purpose of this Article has been to explore the meanings of the
expectation and reliance conceptions of damages, and to develop the
basic formulas through which these conceptions can be expressed. A sec-
ond purpose has been to show that the expectation conception has a
sound basis in both fairness and policy. As a matter of fairness, one who
breaches a contract ought at a minimum to compensate the promisee's
reliance, and in many or most cases the expectation measure yields virtu-
ally the same damages as the reliance measure, but is much easier to
administer. As a matter of policy, expectation damages best facilitate
planning. As a matter of both fairness and policy, a damage measure is
appropriate if it is the measure the parties probably would have chosen if
they had bargained under ideal conditions and addressed the issue, and
in most cases the parties to a bargain probably would have chosen the
50. RESTATEMENT OF CoNTRACTS § 90 (1932).

51. Fuller & Perdue, The Reliance Interestin ContractDamages (pts. 1 & 2), 46 YALE L.J. 52,
373 (1936-1937).
52. See, e.g., P.S. ATrYAH, THE RISE AND FALL OF FREEDOM OF CONTRAcT 1-7, 754-64
(1979); see also Horwitz, The HistoricalFoundationsof Modern Contract Law, 87 HARv. L. REv.
917 (1974).

expectation measure, because it protects reliance, facilitates planning,

and provides the correct incentives for performance and precaution.
Another purpose of this Article has been to show that the term
expectation is itself ambiguous. One meaning of the term, which we call
the expectation principle, is that a victim of breach should be put in the
position he would have been if the contract had been performed. A sec-
ond meaning, which we call the expectation theory, is that damages
should be based on the measure that parties situated like the contracting
parties probably would have agreed to, if they had bargained under ideal
conditions and addressed the damages issue. Still a third meaning, which
we call statistical expectation, is that if a person makes a number of com-
parable contracts with a known probable rate of breach, he should enjoy
the overall profit level he expected to achieve, rather than the profit level
he would have achieved if the rate of breach were zero. We suggest that
where the expectation principle and the expectation theory diverge-
which is particularly likely where a seller forms a statistical expecta-
tion-the theory rather than the principle should govern. Thus in many
cases involving consumers, where damages under the expectation princi-
ple would be measured by the seller's lost volume, the parties would
probably have agreed to a much smaller measure of damages (such as
forfeit of a deposit) if they had addressed the issue. It is this measure
that should govern.
Indeed, it seems likely that the assault by some commentators on
expectation damages results in part from the intuition that damages mea-
sured under the expectation principle are out of place in just such cases.
This intuition is correct, but the way the problem should be dealt with is
not by denying expectation damages, but by reconceptualizing the expec-
tation interest in such cases through use of the expectation theory.

APPENDIX
In this Appendix, we illustrate in mathematical terms, by reference

to Figure 3, the application of the substitute-price, lost-surplus, opportu-
nity-cost, and out-of-pocket-cost formulas to a breach in a competitive
market where the rate of breach is low and the parties' business conduct
is described by the traditional model.
A. Substitute-Priceand Opportunity-CostDamages
We begin with the substitute-price formula. The vertical distance in
Figure 3 between Pk and ps represents the shortfall in Seller's profits
caused by Buyer's breach of a contract to buy one unit of the good. We
can put Seller in the position that he would have been in if Buyer had
performed, thus protecting Seller's expectation interest, by setting com-
pensation under the substitute-price formula, at Pk - ps per unit of
breach. For example, if Buyer breaches a contract to purchase Xk units,
then the substitute-price formula yields damages of Xk (Pk - ps), which
correspond to area A + B in Figure 3. The revenue from damages com-
bined with the revenue from spot sales XkPs will restore Seller's revenue
to the level that would have been enjoyed from Buyer's performance.
Thus, where the market is perfectly competitive, the Seller's business
conduct is described by the traditional model, and the probability of
breach is small, the substitute-price formula provides the correct measure
of damages under the expectation principle.
Making the contract caused Seller to forgo the opportunity of con-
tracting with another buyer at the price pk. Therefore, we can put Seller
in the position that he would have been in if he had not contracted with
Buyer, thus protecting his reliance interest, by setting compensation
under the opportunity-cost formula, which also equals Pk - ps per unit
of breach. Thus, given the specified conditions, the opportunity-cost
formula provides the correct measure of damages under the reliance
principle, and the substitute-price and opportunity-cost formulas yield
the same amounts.
B. Lost-Surplus Damages
We now shift to the lost-surplus formula, which awards an injured
seller the profits he would have enjoyed from performance. In the tradi-
tional model of perfect competition, expected profits are nil on the last
unit of a commodity exchanged in the market (whether simultaneously
or by contract), because each firm supplies (or contracts to supply) the
commodity until cost equals price. If the probability of breach
approaches zero, a firm signs contracts until the contract price equals the
marginal cost of supplying the promised goods. Since seller's surplus is

another name for seller's expected profit, lost-surplus damages (price

minus direct costs) are nil if the only breach that occurs is a breach of a
marginal contract, that is, a contract involving one unit of seller's pro-
duction. To illustrate by the graph of Example A in Figure 3, Seller
supplies the commodity until its marginal cost c equals the contract price
Pk, which occurs at output Xk. Lost-surplus damages for Buyer's breach
at the margin are nil, that is Pk - C = 0.
A similar proposition applies when the roles of buyer and seller are
reversed. If the commodity is continuous, like petroleum, or if it is
purchased in quantity, like oranges (rather than being lumpy and
purchased only occasionally, like boats), then each consumer buys units
of the commodity until the subjective value of the last unit equals its
price. At that point, since the subjective value of the last unit equals the
price, there is no surplus value expected from the last unit. Conse-
quently, lost-surplus damages are nil for seller's breach of a marginal
contract, that is, a contract to supply one unit of buyer's consumption.
The generalization underlying these propositions is that lost-surplus
damages for marginal breach-breach involving one unit of a commod-
ity-are nil for continuous commodities exchanged in competitive mar-
kets with low probabilities of breach. In reality, however, expectation
and reliance damages do occur in such a setting. The seller suffers expec-
tation damages equal to the substitute-price formula, because if the con-
tract had been performed, the seller would have sold the marginal unit at
the contract price Pk rather than the lower spot price p,. The seller suf-
fers opportunity-cost reliance damages, because if not for the contract
with the buyer, the seller would have contracted to sell the marginal unit
to someone else at the same price, and the other buyer probably would
have performed. Correspondingly, the buyer suffers expectation dam-
ages equal to the substitute-price formula, because if the contract had
been performed, the buyer could have resold the marginal unit at a profit
equal to spot price minus contract price. The buyer suffers opportunity-
cost reliance damages, because if not for the contract with the seller, the
buyer would have contracted to buy the marginal unit from someone else
at the same price, and the alternative seller probably would have per-
formed. Accordingly, the lost-surplus formula undercompensates the
expectation and reliance interests for marginal breach in a competitive
market under the traditional model of business conduct.
Suppose that the breach involves a number of units. Even if
expected profits are nil on the last unit sold, they may be positive on the
total units sold. To illustrate, in Figure 3, although the contract pricePk
equals the production cost c for the last or marginal unit, labeled Xk, it
exceeds the cost of production for the units preceding the last, which are
called the "inframarginal" units. Since price exceeds costs on

inframarginal units, a profit is made on their production. Thus lost-sur-

plus damages are positive for buyer's breach on contracts that are large
enough to involve inframarginal units. In such cases, however, lost-sur-
plus damages often would be overcompensatory.
For example, suppose that Buyer contracts with Seller to purchase
all Xk units of the goods at the price Pk. Buyer breaches and Seller is
forced to sell the goods at the spot price p. Lost-surplus damages are
equal to area A + C, that is, the entire area in Figure 3 between the
contract price linepkDk and the cost curve c. If, as a result of the breach,
seller will have available Xk units for sale to third parties, the breach does
not result in a shortfall of profits equal to this area. Rather, it results in a
shortfall equal to area A + B, which corresponds to damages measured
by the substitute-price formula. As drawn, A + C is larger than A + B,
which illustrates that for breach on a large number of units
(inframarginal breach), lost-surplus damages are often overcompensatory
for a seller in a competitive market where the traditional model of busi-
ness conduct applies. Put differently, in such cases the lost-surplus
formula would be appropriate only if it were corrected by an add-on to
account for the surplus-producing transaction that the breach makes pos-
sible-that is, for the sale of the breached unit at a profit equal to the
spot price minus the cost of production. If that correction is made, how-
ever, the lost-surplus formula collapses into the substitute-price formula.
The same kind of argument applies when the victim of breach is a
buyer. A buyer purchases goods until the subjective value of the last unit
is no more than its market price. However, he usually values all but the
last unit at more than the market price he agrees to pay. Thus a buyer's
lost-surplus damages for seller's breach of a contract to supply a large
number of units would equal the surplus the buyer expected to enjoy.
However, this measure often would overcompensate the buyer when a
substitute can be purchased.
In short, lost-surplus damages generally do not provide correct com-
pensation for either the reliance or the expectation interest in competitive
contract markets where the seller supplies commodities until cost equals
price, the seller's conduct is described by the traditional model, and the
rate of breach is low. Under such conditions, therefore, the lost-volume
measure of damages, which is a special variant of the lost-surplus
formula, is inappropriate.
C. Out-of-Pocket-Cost Damages
The out-of-pocket-cost formula awards a victim of breach the excess
of his cost incurred over the realizable value produced by that cost. The
cost incurred by a seller to produce a marginal unit is the marginal cost.
If the breach occurs after the unit has been produced, the realizable value

produced by its cost is normally the commodity's spot price at the time
of breach. Therefore, a seller's out-of-pocket-cost damages for breach on
a completed marginal unit equal the shortfall between marginal cost and
spot price.
Relating out-of-pocket-cost damages to substitute-price damages in
the case of a marginal unit is straightforward. As explained, if the
probability of breach is small and the market is competitive, a seller nor-
mally produces commodities until the contract price equals the marginal
cost. Hence, in the case of a marginal unit the difference between the
marginal cost and the spot price equals the difference between the con-
tract price and the spot price. In sum, seller's out-of-pocket-cost dam-
ages on a marginal unit normally equal substitute-price (and therefore
opportunity-cost) damages where the market is competitive and the
probability of breach is small.
To illustrate by the graph of Example A in Figure 3, substitute-price
(and opportunity-cost) damages are the difference between the contract
price and the spot price: Pk - pr. The out-of-pocket loss from breach on
the last of the Xk units produced is the difference between the marginal
cost, which we denote c (Xk), and the spot price: c (Xk) - p,. As noted,
the seller produces the commodity until its marginal cost equals the con-
tract price, that is, c (Xk) = Pk. Thus, the two damages formulas are
equal; Pk - Ps = C(Xk) - P.
Of course this conclusion is true only for marginal breach. The cost
of inframarginal units, which are any units on the cost curve c except the
last of the Xk units produced, is less than the contract price Pk, as can be
seen from Figure 3. Consequently, out-of-pocket damages on
inframarginal breach will be less than substitute-price damages and, con-
sequently, less than expectation damages.

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Berkeley Law

Berkeley Law Scholarship Repository

Damages for Breach of Contract

Melvin Aron Eisenberg

Follow this and additional works at: https://scholarship.law.berkeley.edu/facpubs

Damages for Breach of Contract

HeinOnline -- 73 Cal. L. Rev. 1432 1985

B. The Limits of the Expectation Principle ................ 1468

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Damages for Breach of Contract

The conventional analysis of contracts holds that the purpose of

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2. See id. § 344(a), (b).

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two different conceptions of compensation. Under the expectation con-

Figure 1: Compensation in Hawkins v. McGee

0% 25% 50% 100%

horizontal axis in this Figure indicates the range of possible conditions of

3. 84 N.H. 114, 146 A. 641 (1929).

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structed so that a change in the patient's condition from one point to

HeinOnline -- 73 Cal. L. Rev. 1437 1985

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substitute-price, lost-surplus, opportunity-cost, out-of-pocket-cost, and

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Figure 2: Opportunity Cost in Hawkins v. McGee

0% 25% 50% 75% 100%

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F Add-ons and Offsets

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expectation principle or the reliance principle. 0 Alternatively, a breach

TABLE 1: DAMAGE FORMULAS

When computing damages, courts usually use some variant of one of

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omitted issues-seller's breach, the diminished-value formula,1 1 add-ons,

As explained in Part I, the expectation and reliance conceptions of

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A. Perfectly Competitive Markets

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In this example, Seller would have contracted with another buyer

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Figure 3: Competitive Market for Customized Goods

Price c Marginal Cost

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to Example A and Example B. We shall do so here in words; the Appen-

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circumstances like Example A and Example B. The out-of-pocket-cost

2. The Statistical-PlanningModel of Business Conduct in Perfectly

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HeinOnline -- 73 Cal. L. Rev. 1450 1985

the seller's business conduct is best described by the traditional model. If

B. Imperfectly Competitive Markets

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HeinOnline -- 73 Cal. L. Rev. 1452 1985

Figure 4: Monopolistic Supplier

Price c Marginal Cost

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Demand When Buyer Orders

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tracted with an alternative buyer, correct damages under the reliance

HeinOnline -- 73 Cal. L. Rev. 1455 1985

Example E: Seller supplies branded plumbingware to plumbing